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ANALYSIS OF FINANCIAL ACCOUNTING THEORY AND METHODOLOGIES
by
Sienna J. Johnson
A thesis submitted to the faculty of the University of Mississippi in partial fulfillment of the requirements of the Sally McDonnell Barksdale Honors College.
Oxford, MS May 2019
Approved by
Advisor: Dr. Vicki Dickinson
Reader: Dean W. Mark Wilder
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ABSTRACT
The following thesis consists of a compilation of eleven case studies pertaining to
various accounting theory and methodologies. Each individual case study begins with an
executive summary consisting of an introduction, analysis, and conclusion. The following
cases were completed throughout the 2017-2018 school year in the course, ACCY 420,
taught by Dr. Vicki Dickinson. The following cases consist of detailed analysis of
financial statements, accounting methods, and the use and implementation of data
analytics software. These cases were individually reviewed and graded throughout the
ACCY 420 course, as well as discussed and analyzed through group discussion. This
thesis has been defended through participation in the PwC & KPMG Accounting Case
Competitions.
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TABLE OF CONTENTS
Abstract……………………………………………………………………………………1
Case Study #1—Home Heaters Inc. …………………………………………………...…3
Case Study #2—Molson Coors Brewing Co. ………………………………………..….16
Case Study #3—Pearson PLC…………………………………………………….……..23
Case Study #4—Palfinger AG………………………………………………………..….33
Case Study #5—Volvo Group…………………………………………………………...43
Case Study #6—Data Analytics…………………………………………………….……54
Case Study #7—Rite Aid Corporation……………………………………………….….66
Case Study #8—Merck & Co. ……………………………………………………..……75
Case Study #9—State Street Corporation…………………………………………….….82
Case Study #10—ZAAG Inc. …………………………………………………………...91
Case Study #11—Apple Inc. ………………………………………………………..….101
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Home Heaters Inc. – Financial Analysis of
Glenwood and Eads
Case Study #1
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Executive Summary
Introduction:
This case study consists of transactions made by two companies, Eads Heaters, Inc. and
Glenwood Heating, Inc. Both companies sell home heating units, operate under similar
economic conditions, and execute identical operations throughout the year. However, at
the end of the year, each manager makes different GAAP decisions regarding accounting
methods, estimates, and purchasing negotiations. Analysis of these differing
methodologies, as well a how they impact the financial statements, reveals the external
repercussions of such decisions. While Glenwood Heating, Inc. and Eads Heaters, Inc.
prove to be nearly identical companies, the different accounting choices made by each
manager alter the financial statements in a way that make one company appear a better
investing or lending option. Based on comparison of the two companies’ financial
statements, Glenwood Heating, Inc. appears to be the better investing or lending option
for external users.
Analysis:
The following points contain justification for the conclusion that, based on the financial
statements, Glenwood Heating, Inc. would be the better company to invest in or lend
money to.
Ø Allowance for Bad debts (Part B: 1): Eads estimates that five percent of their
ending accounts receivable will be uncollectible, while Glenwood has a
significantly lower bad debt estimate of one percent. This illustrates that
Glenwood exhibits less uncertainty in the collection of their receivables, making
them the safer investment option.
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Ø Depreciation of equipment (Part B: 2): Eads predicts a higher rate of depreciation
on the delivery equipment purchased in Part A: No. 5 than Glenwood. This
results in a $20,000 depreciation expense versus Glenwood’s $9,000 depreciation
expense for the year. This estimate ultimately brings down Eads’ retained
earnings as well as their net income.
Ø Operating equipment (Part B: 4): Glenwood and Eads both purchased an identical
large piece of operating equipment; however, Glenwood chose to rent the
equipment for $16,000 a year, while Eads negotiated a capital lease agreement for
$92,000. This results in the recording of a $92,000 long-term lease payable,
drastically increasing Eads’ liabilities as opposed to Glenwood. The inclusion of
this long-term liability adds risk to the company. This results in a higher debt-to-
equity ratio for Eads, portraying that they have greater financial leverage but also
prove to be the riskier investment option.
Conclusion:
This case study exemplifies the effects of accounting choices on external users when
deciding whether to invest or lend money to a company. While these choices may not
directly affect the company in the short-run, they may alter the decisions of external
users, therefore affecting future investment and financing endeavors. In conclusion,
managers should analyze the effects of these GAAP accounting choices on their financial
statements when making decisions.
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Part 1: Glenwood Heating, Inc. Financial Statements
CurrentAssets CurrentLiabilitesCash 426.00$ Accountspayable 26,440.00$Accountsreceivable 99,400.00$ Interestpayable 6,650.00$Allowanceforbaddebts (994.00)$ TotalCurrentLiabilities 33,090.00$Inventory 62,800.00$TotalCurrentAssets 161,632.00$ Long-termLiabilities
Notespayable 380,000.00$Long-termAssets TotalLiabilities 413,090.00$Land 70,000.00$
Building 350,000.00$ EquityEquipment 80,000.00$ Commonstock 160,000.00$Less:Accumulateddepreciation Retainedearnings 69,542.00$Building (10,000.00)$ TotalEquity 229,542.00$Equipment (9,000.00)$
TotalAssets 642,632.00$ TotalLiabilitesandEquity 642,632.00$
GlenwoodHeating,Inc.BalanceSheet
December31,20X1
Assets Liabilities
RevenueSales 398,500.00$
CostofGoodsSold (177,000.00)$
GrossProfit 221,500.00$
ExpensesOtheroperatingexpense (34,200.00)$
Baddebtexpense (994.00)$
Interestexpense (27,650.00)$
Depreciationexpense-building (10,000.00)$
Depreciationexpense-equipment (9,000.00)$
Rentexpense (16,000.00)$
Incomebeforetaxes 123,656.00$
Provisionforincometaxexpense (30,914.00)$
NetIncome 92,742.00$
GlenwoodHeating,Inc.IncomeStatementDecember31,20X1
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Retainedearnings-January1,20X1 -$Plus:Netincome 92,742.00$Less:Dividends (23,200.00)$Retainedearnings-December31,20X1 69,542.00$
December31,20X1
GlenwoodHeating,Inc.StatementofRetainedEarnings
Part 2: Eads Heaters, Inc. Financial Statements
Assets LiabilitiesCurrentAssets CurrentLiabilitesCash 7,835.00$ Accountspayable 26,440.00$A/R 99,400.00$ Interestpayable 6,650.00$Allowanceforbaddebts (4,970.00)$ TotalCurrentLiabilities 33,090.00$Inventory 51,000.00$TotalCurrentAssets 153,265.00$ Long-termLiabilities
Notepayable 380,000.00$Long-termAssets Leasepayable 83,360.00$Land 70,000.00$ TotalLiabilities 496,450.00$Building 350,000.00$
Equipment 80,000.00$ EquityLeasedequipment 92,000.00$ Commonstock 160,000.00$Less:Accumulateddepreciation Retainedearnings 47,315.00$Building (10,000.00)$ TotalEquity 207,315.00$Equipment (20,000.00)$Leasedequipment (11,500.00)$
TotalAssets 703,765.00$ TotalLiabilitesandEquity 703,765.00$
EadsHeater,Inc.BalanceSheet
December31,20X1
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RevenueSales 398,500.00$
CostofGoodsSold (188,800.00)$
GrossProfit 209,700.00$
ExpensesOtheroperatingexpense (34,200.00)$
Baddebtexpense (4,970.00)$
Interestexpense (35,010.00)$
Depreciationexpense-building (10,000.00)$
Depreciationexpense-equipment (20,000.00)$
Depreciationexpense-leasedequipment (11,500.00)$
Incomebeforetaxes 94,020.00$
Provisionforincometaxexpense (23,505.00)$
NetIncome 70,515.00$
EadsHeater,Inc.IncomeStatementDecember31,20X1
Retainedearnings-January1,20X1 -$Plus:Netincome 70,515.00$Less:Dividends (23,200.00)$Retainedearnings-December31,20X1 47,315.00$
EadsHeater,Inc.StatementofRetainedEarnings
December31,20X1
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Appendix A Glenwood Heating, Inc. and Eads Heaters, Inc. Beginning Transactions (Part A):
Cash
Accounts
receivable Inventory Land Building Equipment
No.1 160,000.00$No.2 400,000.00$No.3 (420,000.00)$ 70,000.00$ 350,000.00$No.4 (80,000.00)$ 80,000.00$No.5 239,800.00$No.6 398,500.00$No.7 299,100.00$ (299,100.00)$No.8 (213,360.00)$No.9 (41,000.00)$No.10 (34,200.00)$No.11 (23,200.00)$No.12
Balances 47,340.00$ 99,400.00$ 239,800.00$ 70,000.00$ 350,000.00$ 80,000.00$
Assets
Accountspayable Notespayable
InterestPayable
Commonstock
RetainedEarnings
No.1 160,000.00$No.2 400,000.00$No.3No.4No.5 239,800.00$No.6 398,500.00$No.7No.8 (213,360.00)$No.9 (20,000.00)$ (21,000.00)$No.10 (34,200.00)$No.11 (23,200.00)$No.12 6,650.00$ (6,650.00)$Balances 26,440.00$ 380,000.00$ 6,650.00$ 160,000.00$ 313,450.00$
Liabilities Equity
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Appendix B Glenwood Heating, Inc. Ending Transactions (Part B):
Cash
Accounts
receivable
Allowance
forbad
debts Inventory Land Building
Accumulated
depreciation-
building Equipment
Accumulated
depreciation-
equipment
Balances:PartA 47,340.00$ 99,400.00$ $- 239,800.00$ 70,000.00$ 350,000.00$ $- 80,000.00$ $-PartB(1)Baddebts 994.00$PartB(2)COGS (177,000.00)$PartB(3)Depreciation
Building 10,000.00$Equipment 9,000.00$PartB(4)Equipment
RentalPayment (16,000.00)$PartB(5)Incometax (30,914.00)$Balances 426.00$ 99,400.00$ 994.00$ 62,800.00$ 70,000.00$ 350,000.00$ 10,000.00$ 80,000.00$ 9,000.00$
Assets
Accountspayable
InterestPayable
Notespayable
Commonstock
RetainedEarnings
Balances:PartA 26,440.00$ 6,650.00$ 380,000.00$ 160,000.00$ 313,450.00$PartB(1)Baddebts (994.00)$PartB(2)COGS (177,000.00)$PartB(3)DepreciationBuilding (10,000.00)$Equipment (9,000.00)$PartB(4)EquipmentRentalPayment (16,000.00)$PartB(5)Incometax (30,914.00)$Balances 26,440.00$ 6,650.00$ 380,000.00$ 160,000.00$ 69,542.00$
Liabilities Equity
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Glenwood Heating, Inc. Adjusted Trial Balance (Part B):
Debits CreditsCash 426.00$Accountsreceivable 99,400.00$Allowanceforbaddebts 994.00$Inventory 62,800.00$Land 70,000.00$Building 350,000.00$Accumulateddepreciation-building 10,000.00$Equipment 80,000.00$Accumulateddepreciation-equipment 9,000.00$Accountspayable 26,440.00$Notespayable 380,000.00$Interestpayable 6,650.00$Commonstock 160,000.00$Dividend 23,200.00$Sales 398,500.00$Costofgoodssold 177,000.00$Otheroperatingexpenses 34,200.00$Interestexpense 27,650.00$Baddebtsexpense 994.00$Depreciationexpense-building 10,000.00$Depreciationexpense-equipment 9,000.00$Rentexpense 16,000.00$Provisionforincometax 30,914.00$Total 991,584.00$ 991,584.00$
GlenwoodHeating,Inc.PartB:TrialBalance
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Appendix C Eads Heaters, Inc. Ending Transactions (Part B):
Cash
Accounts
receivable
Allowancefor
Baddebts Inventory Land Building
Balances:PartA 47,340.00$ 99,400.00$ -$ 239,800.00$ 70,000.00$ 350,000.00$PartB(1)Baddebts 4,970.00$PartB(2)COGS (188,800.00)$PartB(3)Depreciation
Building
Equipment
PartB(4)Equipment
Lease
Leasepayment (16,000.00)$Depreciation
PartB(5)Incometax (23,505.00)$Balances 7,835.00$ 99,400.00$ 4,970.00$ 51,000.00$ 70,000.00$ 350,000.00$
Assets
Accumulateddepreciation-
building Equipment
Accumulateddepreciation-equipment
Leasedequipment
Accumulateddepreciation-
leasedequipment
Balances:PartA -$ 80,000.00$ -$ -$ -$PartB(1)Baddebts
PartB(2)COGS
PartB(3)Depreciation
Building 10,000.00$Equipment 20,000.00$PartB(4)Equipment
Lease 92,000.00$Leasepayment
Depreciation 11,500.00$PartB(5)IncometaxBalances 10,000.00$ 80,000.00$ 20,000.00$ 92,000.00$ 11,500.00$
Assets
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Accountspayable
Interestpayable Notespayable Leasepayable Commonstock
Retainedearnings
Balances:PartA 26,440.00$ 6,650.00$ 380,000.00$ -$ 160,000.00$ 313,450.00$PartB(1)Baddebts (4,970.00)$PartB(2)COGS (188,800.00)$PartB(3)DepreciationBuilding (10,000.00)$Equipment (20,000.00)$PartB(4)EquipmentLease 92,000.00$Leasepayment (8,640.00)$ (7,360.00)$Depreciation (11,500.00)$PartB(5)Incometax (23,505.00)$Balances 26,440.00$ 6,650.00$ 380,000.00$ 83,360.00$ 160,000.00$ 47,315.00$
Liabilities Equity
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Eads Heaters, Inc. Adjusted Trial Balance (Part B):
Debits Credits
Cash 7,835.00$Accountsreceivable 99,400.00$AllowanceforBaddebts 4,970.00$Inventory 51,000.00$Land 70,000.00$Building 350,000.00$Accumulated
depreciation-building 10,000.00$Equipment 80,000.00$Accumulated
depreciation-equipment 20,000.00$Leasedequipment 92,000.00$Accumulated
depreciation-leased
equipment 11,500.00$Accountspayable 26,440.00$Notespayable 380,000.00$Interestpayable 6,650.00$Leasepayable 83,360.00$Commonstock 160,000.00$Dividend 23,200.00$Sales 398,500.00$Costofgoodssold 188,800.00$Otheroperatingexpenses 34,200.00$Baddebtsexpense 4,970.00$Depreciationexpense-
building 10,000.00$Depreciationexpense-
equipment 20,000.00$Depreciationexpense-
leasedequipment 11,500.00$Interestexpense 35,010.00$Provisionforincometax 23,505.00$Total 1,101,420.00$ 1,101,420.00$
EadsHeaters,Inc.PartB:TrialBalance
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Appendix D Bad debts expense calculations: Glenwood Heating, Inc.: $99,400 x .01= $994
Eads Heaters, Inc.: $99,400 x 0.05= $4,970
Equipment depreciation expense calculations:
Glenwood Heating, Inc.: ($80,000- $8,000)/8= $9,000
Eads Heaters, Inc.: 80,000 x 1/8 x 2= $20,000
Debt-to-equity ratio:
Glenwood Heating, Inc.: 413,090/229,542=1.8
Eads Heaters, Inc.: 496,450/207,315=2.4
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Molson Coors Brewing Co. – Profitability &
Earnings Persistence
Case Study #2
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Executive Summary
Introduction:
Molson Coors Brewing Company was formed on February 9, 2005 resulting from the
merging of Adolph Coors Company and Molson Inc. Molson Coors is committed to
producing the highest-quality beers and appeal to a wide range of consumer tastes, styles,
and preferences. This case study contains Molson Coors’ Consolidated Income
Statement, Consolidated Statements of Comprehensive Income, Consolidated Balance
Sheet, as well as the notes pertaining to these consolidated financial statements.
Questions pertaining to the company’s 2013 Income Statement and Statement of
Comprehensive Income are addressed in this case.
Analysis:
Parts A, B, C, and D of this case focus on concepts relating to the income statement and
statement of comprehensive income. Molson Coors chose wisely in choosing to present a
classified income statement because investors and creditors viewing their financial
statements will be able to form a better understanding of the company’s current financial
standing, as well as their ability to generate future cash flows. Molson Coors presents a
persistent measure of income, adding consistency to the company’s financial statements.
Molson Coors also differentiates between net income and comprehensive income, aiding
investors and creditors in assessing the company and providing them with the information
necessary to make decisions. Parts E, F, G, and H focus on the processes involved in
Molson Coors’ financial statements. Molson Coors’ successfully classifies items such as
sales, net sales, special items, and other income (expense) in a way that distinguishes the
differences between these items. The separation of net income and comprehensive
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income also adds detail to the financial statements, increasing users’ abilities to
accurately assess the company. Finally, Part J of this case involves the effective tax rate
and the process involved its calculation.
Conclusion:
This case has helped me to realize the value and importance of a company’s ability to
successfully classify their financial statements, as well as include sufficient detail so that
investors and creditors may accurately assess the company. I have also gained a greater
appreciation for the notes included with the financial statements. I now see the
importance of clarifying why a company classifies items in a certain way, as well as what
kind of items are included in these classifications. This case has made me realize how
beneficial notes can be in providing investors and creditors with the material necessary
for a full understanding of the company.
a. What are the major classifications on an income statement?
Ø Sales or Revenue—Presents sales, sales discounts, sales returns and allowances,
and other related information. The subtotal “net sales” is determined at the end of
this section.
Ø Cost of Goods Sold—Shows the cost of goods that were sold to generate sales.
Ø Operating Expenses: Selling Expenses—Expenses resulting from the
company’s efforts to generate sales (i.e. Sales salary expense, delivery expense,
advertising expense)
Ø Operating Expenses: Administrative or General Expenses—Expenses of
general administration (i.e. Office salary expense, utilities expense, insurance
expense)
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Ø Other Revenues and Gains—Revenues recognized or gains incurred as a result
of non-operating activities
Ø Other Expenses and Losses—Expenses recognized or losses incurred as a result
of non-operating activities
Ø Income Tax—Federal and state taxes levied on income from continuing
operations
Ø Discontinued Operations—Gains or losses resulting from the disposal of a
certain product line or segment of a company’s business
Ø Non-controlling Interest—An allocation of income to non-controlling
shareholders
Ø Earnings Per Share- A measure of performance over the reporting period.
Earnings per share is calculated by dividing net income less preferred dividends
by the weighted average of common shares outstanding.
b. Why does U.S. GAAP require companies to provide “classified” income
statements?
Ø U.S. GAAP requires companies to provide “classified” income statements
because this form provides investors and creditors with the most detail. Being
that most decision-makers find the parts of a financial statement to be more useful
than the whole, it is crucial that companies provide as much detail in their
financial statements as possible. Providing this detail allows decision-makers to
better assess future income and cash flows.
c. Why might financial statement users be interested in a measure of persistent
income?
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Ø Financial statement users are interested in a measure of persistent income so that
they may compare the company’s financial statements from year to year.
Measures of persistent income improve the comparability as well as the
consistency of the company’s financial statements. A persistent income also aids
in the user’s ability to predict the nature and timing of future cash flows.
d. What is comprehensive income and how does it differ from net income?
Ø Comprehensive income includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners.
Comprehensive income differs from net income in that it provides a broader
measure of income by including income and expenses that have not yet been
realized by the company.
e. What is the difference between “Sales” and “Net sales?” Why does Molson
Coors report these two items separately?
Ø Sales are the total amount of revenue a company receives from transactions, while
net sales include deductions from sales returns and allowances and sales
discounts. Molson Coors reports these two items separately so that users can
differentiate between the initial revenue generated from sales and the net value of
sales after deductions have been made.
f. Consider the income statement items “Special items, net” and information in
Notes 1 and 8.
i. What types of items does Molson Coors include in this line item?
Ø Molson Coors records items that are not indicative of their core operations as
“special items.” Specifically, Molson Coors considers these special items to be
one of the following: infrequent or unusual items, impairment or asset
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abandonment-related losses, restructuring charges and other atypical employee-
related costs, or fees on termination of significant operating agreements and gains
(losses) on disposal of investments.
ii. Why does the company report these on a separate line item rather
than including them with another expense item? Do you agree
with Molson Coors decision to classify these items as operating
expenses?
Ø The company records these special items on a special line item in order to
differentiate them from other expenses. Special items differ from the company’s
other expenses in that they are a product of activities not indicative of the
company’s core operations. However, special items should be included as an
operating expense because while they are not related to the company’s core
operations, they do deal with operating related activities.
g. Consider the income statement item “Other income (expense), net” and the
information in Note 6. What is the distinction between “Other income
(expense), net” which is classified a non-operating expense, and “Special
items, net” which Molson Coors classifies as operating expenses?
Ø The distinction between other income expenses and special items pertains to their
incorporation with the company’s operations. While special items are unusual
and unrelated to core operations, they still pertain to the company’s operations;
therefore, justifying their classification in the operating expense category. On the
other hand, other income expenses are completely unrelated to the company’s
operations; therefore, they should be classified as a non-operating expense.
h. Refer to the statement of comprehensive income.
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i. What is the amount of comprehensive income in 2013? How does this
amount compare to net income in 2013?
Ø Molson Coors’ comprehensive income in 2013 was $765.40 while net income
was $572.50. The comprehensive income amount is greater than the amount of
net income because it represents a broader measure of income, including items
not yet realized by the company.
ii. What accounts for the difference between net income and
comprehensive income in 2013? How are the items included in Molson
Coors’ comprehensive income related?
Ø Comprehensive income differs from net income due to the inclusion of foreign
currency translation adjustments, an unrealized gain on derivative instruments,
reclassification of derivative loss to income, pension and other postretirement
benefit adjustments, amortization of net prior service benefit cost and net actuarial
gain to income, and ownership share of unconsolidated subsidiaries’ other
comprehensive income. These items are considered to be “dirty surplus” items.
These items are volatile and are not easily predictable; therefore, they are
included in the broader category of income (comprehensive income) but not in the
calculation of net income. They are not included in net income so that they do not
negatively affect the decisions of investors and creditors when analyzing the
company’s net income.
j. What is Molson Coors’ effective tax rate in 2013?
Ø Molson Coors’ effective tax rate in 2013 is 12.8%. This rate derives from the
division of income tax expense by the company’s pre-tax income.
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Pearson PLC – Accounts Receivable
Case Study #3
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Executive Summary
Introduction:
Headquartered in London, England, Pearson is an international company with businesses
in education, business information, and consumer publishing. This case includes the
company’s Consolidated Income Statement, Consolidated Statement of Comprehensive
Income, Consolidated Balance Sheet, and essential notes to these 2009 financial
statements. This case focuses on accounts receivable, as well as certain contra accounts
such as allowance for doubtful accounts and allowance for sales returns and allowances.
This case relays information relating to the definitions of these accounts, methods in
which companies estimate allowances, and the identification and analysis of these
accounts in Pearson’s consolidated financial statements and footnotes.
Analysis:
Parts A, B, and C of this case provide information on accounts receivable and contra
accounts. In part C, the allowance for doubtful accounts and allowance for sales returns
and allowances are identified as contra accounts present in Pearson’s financial
statements. Part D presents two different methods companies use in determining
estimates for these contra accounts, the percentage-of-sales procedure and aging-of-
accounts procedure. While both of these methods are used by companies when
producing allowance estimates, the aging-of-accounts procedure proves to yield the most
accurate estimates because it deals with each account individually and uses the
characteristic of time to determine potentially uncollectible accounts. Part E provides
information regarding why companies continue to extend credit to customers even though
there is risk that these accounts will be uncollectible. While companies will always face
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risk when extending credit, the risk of dealing with credit sales is outweighed by the
benefit of increased sales that these credit ventures yield. However, the risks could
potentially outweigh the benefits if management does not successfully estimate an
accurate allowance for these potentially uncollectible accounts. Parts F, G, and H present
Pearson’s allowance for doubtful accounts, allowance for sales returns and allowances,
and accounts receivable T-accounts as well as the journal entries that go along with
certain transactions. It is interesting to note the way in which the activity in allowance
for doubtful accounts and sales returns and allowances ultimately affect accounts
receivable.
Conclusion:
This case has provided me with a greater understanding of receivables, as well as
allowance for doubtful accounts and sales returns and allowances. The portrayal of how
these contra accounts affect the company’s receivables have helped me to gain awareness
of just how important it is for management to provide accurate estimates for these varies
accounts.
A. What is an account receivable? What other names does this asset go by?
Ø Account receivables are oral promises of the purchaser to pay for goods and
services sold. These assets represent “open accounts” resulting from short-term
extensions of credit, and are usually collected within 30-60 days. These assets
may also be referred to as “trade receivables.”
B. How do accounts receivable differ from notes receivable?
Ø Accounts receivables differ from notes receivables in that notes receivables are
generally written promises to pay a certain sum of money on a specified future
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date, while accounts receivables are usually oral promises. While accounts
receivables are generally short-term credit extensions collected within 30-60 days,
notes receivables may consist of short-term or long-term agreements.
C. What is a contra account? What two contra accounts are associated with
Pearson’s trade receivables? What types of activities are captured in each of these
contra accounts? Describe factors that managers might consider when deciding how
to estimate the balance in each of these contra accounts?
Ø A contra account is an account that deducts from the balance of an ordinary
account. For example, the contra asset account, allowance for doubtful accounts,
is subtracted from the gross accounts receivable balance yielding a net accounts
receivable balance.
Ø The two contra accounts associated with Pearson’s trade receivables are the
provisions for bad and doubtful debts account (i.e. allowance for doubtful
accounts) and provision for sales returns account (i.e. sales returns and
allowances). The allowance for doubtful accounts increases when the company
credits the account for the estimation of uncollectible receivables, and decreases
when the company debits the account in using up the allowance to write-off
uncollectible accounts. The allowance for sales returns and allowances account is
similar in that it increases with a debit for the estimation of sales returns and
allowances, and decreases with a credit when the actual sales returns are made.
Ø Mangers might consider factors such as the company’s history with collecting
receivables, specific customer performance, the age of the receivable, the volume
of sales made during the year, and many other various factors when estimating the
allowance for each of these accounts.
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D. Two commonly used approaches for estimating uncollectible accounts
receivable are the percentage-of-sales procedure and the aging-of-accounts
procedure. Briefly describe these two approaches. What information do managers
need to determine the activity and final account balance under each approach?
Which of these two approaches do you think results in a more accurate estimate of
net accounts receivable?
Ø The percentage-of-sales method uses a percentage of sales volume for a given
period to accurately estimate the uncollectible credit sales for that period. The
aging-of-accounts method uses the amount of time receivables have been
outstanding to estimate the number of uncollectible receivables.
Ø Both of these methods require the use of historical information. For the aging-of-
accounts method, managers need information regarding the amount of time the
receivables have been outstanding, and, based on this amount of time, what
percentage of these accounts should be estimated as bad debts. For the
percentage-of-sales procedure, managers need information regarding the total
amount of sales and any changes in credit policies, as well as historical
information regarding the company’s past performance.
Ø The aging-of-receivables approach will yield a more accurate estimate of bad
debts because the individual accounts are being actively analyzed based on the
specific characteristic of time, as opposed to all being lumped together to create a
single estimate. While the percent-of-sales method gives a generalized, less
reliable estimate based on past performance, the aging-of-receivables method
29
provides a specific estimate based on current assumptions and measurable
variables; therefore, yielding a more accurate estimate.
E. If Pearson anticipates that some accounts will be uncollectible, why did the
company extend credit to those customers in the first place? Discuss the risks
managers must consider with respect to accounts receivable.
Ø The company continues to extend credit to these customers because it believes
that the risk of not collecting on account is less than the amount of sales that
would potentially be lost if the company only dealt in cash or did not make credit
sales to these customers in the first place. In other words, the risk of not
collecting accounts is outweighed by the benefit of the boost in sales when credit
is extended. Businesses always run the risk of not collecting when extending
credit, especially to new customers with no performance history. Management
must allow for this when estimating bad debts and ensure an accurate allowance is
established so that the company is not negatively impacted by uncollected
accounts.
F. Note 22 reports the balance in Pearson’s allowance for bad and doubtful debts
(for trade receivables) and reports the account activity (“movements”) during the
year ended December 31, 2009.
i. Use the information in Note 22 to complete a T-account that shows the
activity in the allowance for bad debts account during the year.
Explain the line items that reconcile the change in account during
2009.
30
Allowance for Doubtful Accounts Beginning balance £72 Exchange differences 5 Income statement movements 26
Acquisition through business combination 3
End of year balance £76
Ø The “exchange differences” line item results from Pearson engaging in
international business, therefore dealing with different currencies. When these
various currencies are exchanged for British pounds, the exchange rate may
differ, resulting in either a loss or gain for the company. This year, these
“exchange differences” resulted in a loss for the company, therefore reducing
allowance for doubtful accounts.
Ø The “income statement movements” line item results from the company having an
increase in estimated bad debt expense for the following year.
Ø The “utilized” line item is a product of the company actually writing-off
uncollectible accounts throughout the period.
Ø The “acquisitions through business combination” line item is a result of Pearson
acquiring another company, therefore taking on the company’s allowance
accounts as well.
ii. Prepare the journal entries that Pearson recorded during 2009 to
capture 1) bad and doubtful debts expense for 2009 (that is, the
“income statement movements”) and 2) the write-off of accounts
receivable (that is, the amount “utilized”) during 2009. For each
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account in your journal entries, note whether the account is a balance
sheet or income statement account.
1) Bad debt expense (IS) £26
Allowance for doubtful accounts (BS) £26
2) Allowance for doubtful accounts (BS) £20 Accounts receivable (BS) £20
iii. Where in the income statement is the provision for bad and doubtful
debts expense included?
Ø The bad debt expense is included in the company’s selling, general and
administrative expenses on the income statement.
G. Note 22 reports that the balance in Pearson’s provision for sales returns was
£372 at December 31, 2008 and £354 at December 31, 2009. Under U.S. GAAP, this
contra account is typically referred to as an “allowance” and reflects the company’s
anticipated sales returns.
i. Complete a T-account that shows the activity in the provision for sales
returns account during the year. Assume that Pearson estimated that
returns relating to 2009 Sales to be 425 million. In reconciling the
change in the account, two types of journal entries are required, one
to record the estimated sales returns for the period and one to record
the amount of actual book returns.
Allowance for Sales Returns and Allowances
Beginning balance £372 Estimated sales returns 425 Actual sales returns 443 End of year balance £354
32
ii. Prepare the journal entries that Pearson recorded during 2009 to
capture 1) the 2009 estimated sales returns and 2) the amount of
actual book returns during 2009. In your answer, note whether each
account in the journal entries is a balance sheet or income statement
account.
1) Sales returns (IS) £425
Allowance for sales returns and allowances (BS) £425
2) Sales returns (IS) £443 Accounts receivable (BS) £443
iii. In which income statement line item does the amount of 2009
estimated sales returns appear?
Ø The amount of 2009 estimated sales returns appears as a reduction to gross sales
on the income statement.
H. Create a T-account for total or gross trade receivables (that is, trade receivables
before deducting the provision for bad and doubtful debts and the provision for
sales returns). Analyze the change in this T-account between December 31, 2008
and 2009. Assume that all sales in 2009 were on account. That is, they are all
“credit sales.” You may assume that there were no changes to the account due to
business combinations or foreign exchange changes. Prepare the journal entries to
record the sales on account and accounts receivable collection activity in this
account during the year.
33
Accounts Receivable Beginning balance £1,342 Credit sales 5,642 Cash collections 5,237 Write-off of bad debts 20 Sales returns 443 End of year balance £1,284
1) Accounts receivable £5,642 Sales £5,642 2) Cash £5,237 Accounts receivable £5,237
34
Palfinger AG – Property, Plant, &
Equipment
Case Study #4
35
Executive Summary
Introduction:
Headquartered in Bergheim, Austria, Palfinger AG manufactures hydraulic lifting,
loading, and handling solutions. Palfinger manufactures a variety of different kinds of
cranes, such as the knuckle boom crane, timber recycling crane, and the telescopic crane.
In addition to cranes, Palfinger also manufactures several other handling machineries
such as container handling systems, tailgates, aerial work platforms, forklifts, and railway
systems. Being that Palfinger manufactures equipment, and also requires the use of other
pieces of equipment in the process of this manufacturing, the company’s “Property, plant,
and equipment” proves to be its largest and most important asset. The way in which
Palfinger accounts for and depreciates its property, plant, and equipment is vital to the
success of the company.
Analysis:
Being that Palfinger’s primary asset is its property, plant, and equipment, this case
focuses primarily on the topics of PPE and depreciation. Parts A-F of this case focus on
concepts behind Palfinger’s property, plant, and equipment and how they depreciate these
assets. PPE consists of non-current or long-term assets that a company uses in its
operations. The PPE for Palfinger most likely includes cranes, heavy machinery, trucks,
warehouses, production facilities, and land. Palfinger accounts for its PPE in the body of
the financial statements, as well as in the notes to these financial statements. Palfinger
chooses to depreciate its assets using the straight-line depreciation method, which seems
appropriate considering the PPE used in operations should generally depreciate on a
steady basis. However, if Palfinger recognizes that a substantial percentage of its
36
equipment becomes obsolete or unusable before it can be fully depreciated to its salvage
value, the company may want to consider switching to the double-declining-balance
depreciation method. This method recognizes accelerated depreciation in the early years
of the assets useful life. Parts G-J regard the processes in which Palfinger depreciates and
accounts for its PPE. The amounts for purchases of new PPE, government grants,
depreciation expense, and net book value of disposed assets are provided in this section.
Tables containing Palfinger’s depreciation expense as well as net book value of its PPE
using both depreciation methods is also provided. Interestingly, the total income
statement effect of the sale of equipment did not differ with the use of either depreciation
method.
Conclusion:
This case provided me with a large amount of new knowledge regarding property, plant,
and equipment as well as its depreciation. The use of the different depreciation methods,
and their impact on depreciation expense as well as net book value of the company’s PPE
was interesting to note. It is very important for a company to know the rate in which their
equipment depreciates, and choose a depreciation method that aligns closely with this
physical depreciation. This alignment will provide the most accurate value of PPE, as
well as the most accurate depreciation expense and net income for the company. Overall,
this case made me realize the importance of the valuation and depreciation of property,
plant, and equipment.
37
a. Based on the description of Palfinger above, what sort of property and equipment
do you think the company has?
Ø Being that Palfinger manufacturers hydraulic lifting, loading, and handling
solutions, Palfinger most likely has property and equipment of cranes,
warehouses, transportation vehicles (trucks), factories, and land for these
factories.
b. The 2007 balance sheet shows property, plant, and equipment of €149,990. What
does this number represent?
Ø This number represents Palfinger’s long-term or noncurrent assets. These assets
are valued at their historical cost on the balance sheet.
c. What types of equipment does Palfinger report in notes to the financial
statements?
Ø Palfinger reports their own buildings as well as investments in third-party
buildings, plant and machinery, and fixtures, fittings, and equipment in the notes
to their financial statements.
d. In the notes, Palfinger reports “Prepayments and assets under construction.”
What does this sub-account represent? Why does this account have no accumulated
depreciation? Explain the reclassification of €14,958 in this account during 2007.
Ø The subaccount of “Prepayments and assets under construction” represents
advance payments made by the company to acquire new assets and assets that are
38
currently under construction. These assets are grouped together in a separate sub-
account due to the fact that they both do not require depreciation because they are
not currently being used in the company’s operations. Instead, once the prepaid
assets are attained and the assets under construction are completed, they are added
to the “Property, plant, and equipment” section of the balance sheet and
depreciated. The 2007 reclassification of €14,958 is due to the company putting
these assets into operations, therefore taking them out of the sub-account and
putting them into the “Property, plant, and equipment” account on the balance
sheet. These assets are now subject to depreciation because they are now available
for use.
e. How does Palfinger depreciate its property and equipment? Does this policy seem
reasonable? Explain the trade-offs management makes in choosing a depreciation
policy.
Ø Palfinger depreciates its property and equipment using the straight-line method.
This seems like a reasonable depreciation method because the machinery the
company uses in their operations does not generally have an accelerated
depreciation during the early years of its operations. Instead, this machinery
depreciates at a generally steady and consistent pace throughout its useful life.
However, Palfinger could potentially realize an inaccurate amount of accumulated
depreciation with the straight-line method if its equipment becomes obsolete or
outdated before it reaches salvage value. If this is the case for a majority of
Palfinger’s equipment, the company may need to consider switching to the
double-declining-balance depreciation method.
39
f. Palfinger routinely opts to perform major renovations and value-enhancing
modifications to equipment and buildings rather than buy new assets. How does
Palfinger treat these expenditures? What is the alternative accounting treatment?
Ø Palfinger treats these renovation and value-enhancing modification expenses as
current expenses recognized in the year in which they occur. These expenses are
capitalized and depreciated over either the new, or original useful life of the asset.
An alternative treatment for these renovations and value-enhancing modifications
would be to subtract the value of the renovation from the accumulated
depreciation of the asset.
g. Use the information in the financial statement notes to analyze the activity in the
“Property, plant and equipment” and “Accumulated depreciation and impairment”
accounts for 2007. Determine the following amounts:
Ø The purchase of new property, plant and equipment in fiscal 2007.
Ø The purchases of new PPE assets are recorded in the “additions” line found in
financial statement notes. The amount of these purchases is stated as €61, 444.
Ø Government grants for purchases of new property, plant, and equipment in 2007.
Explain what these grants are and why they are deducted from the property, plant,
and equipment account.
Ø Government grants for purchases of new PPE in 2007 are €733. These grants are
deducted from PPE in order to reduce the purchase price to the net realizable
value of the asset.
40
Ø Depreciation expense for fiscal 2007.
Ø The depreciation expense for 2007 is €12,557.
Ø The new book value of property, plant, and equipment that Palfinger disposed of
in fiscal 2007.
Ø The net book value of the PPE that Palfinger disposed of in 2007 is €1,501. This
amount represents the historical cost of the assets less their accumulated
depreciation.
h. The statement of cash flows (not presented) reports that Palfinger received
proceeds on the sale of property, plant, and equipment amounting to €1,655 in fiscal
2007. Calculate the gain or loss that Palfinger incurred on this transaction. Hint: use
the book value you calculated in part g above. Explain what this gain or loss
represents in economic terms.
Ø Palfinger incurred a gain of €154 during this transaction. This gain represents a
period of economic inflation, resulting in a higher fair value price for Palfinger’s
PPE.
i. Consider the €10,673 added to “Other plant, fixtures, fittings, and equipment”
during fiscal 2007. Assume that these net assets have an expected useful life of five
years and a salvage value of €1,273. Prepare a table showing the depreciation
expense and net book value of this equipment over its expected life assuming that
Palfinger recorded a full year of depreciation in 2007 and the company uses:
41
Ø Straight-line depreciation.
Straight-Line Depreciation
Depreciation Expense Net Book Value
2007 € 1,880.00 € 8,793.00
2008 € 1,880.00 € 6,913.00
2009 € 1,880.00 € 5,033.00
2010 € 1,880.00 € 3,153.00
2011 € 1,880.00 € 1,273.00
Ø Double-declining-balance depreciation.
Double-Declining-Balance Depreciation
Depreciation Expense Net Book Value
2007 € 4,269.20 € 6,403.80
2008 € 2,561.52 € 3,842.28
2009 € 1,536.91 € 2,305.37
2010 € 922.15 € 1,383.22
2011 € 110.22 € 1,273.00
42
j. Assume that the equipment from part i. Was sold on the first day of fiscal 2008 for
proceeds of €7,500. Assume that Palfinger’s accounting policy is to take no
depreciation in the year of sale.
Calculate any gain or loss on this transaction assuming that the company used
straight-line depreciation. What is the total income statement impact of the
equipment for the two years that Palfinger owned it? Consider the gain or loss on
disposal as well as the total depreciation recorded on the equipment (i.e. the amount
from part i.)
Ø The loss from this transaction can be calculated by subtracting the proceeds from
the sale of €7,500 from the net book value from the previous year of €8,793. This
calculation (€8,793-€7,500) yields a loss of €1,293. This loss would appear in the
“Other expense and losses” section of the income statement, negatively affecting
the company’s net income for 2008. In the two years that Palfinger owned the
equipment, the total income statement impact would include the equipment’s
accumulated depreciation from the previous year, plus the loss of €1,293 realized
from the sale of the equipment. This calculation results in a total two-year income
statement impact from the equipment of €3,173.
Calculate any gain or loss on this transaction assuming the company used double-
declining-balance depreciation. What is the total income statement impact of this
equipment for the two years that Palfinger owned them? Consider the gain or loss
on disposal as well as the total depreciation recorded on the equipment (i.e. the
amount from part i.)
43
Ø If using double-declining-balance depreciation, the company would record a
€1,097 gain from the sale of equipment. This gain would appear in the “Other
revenues and gains” section of the balance sheet for 2008. This gain offsets
€1,097 of depreciation expense for the equipment on the income statement,
resulting in a total two-year income statement effect of €3,173.
Compare the total two-year income statement impact of the equipment under the
two depreciation policies. Comment on the difference.
Ø While the income statement effects of the sale of equipment using different
depreciation methods resulted in the use of different values for the ultimate
calculation of total income statement effects, the final value of the equipment’s
effect on the income statement proved to be identical with either method. This is
because with the straight-line method, depreciation expense for the equipment is
lower; however, the company recognizes a loss from the sale of the equipment.
With double-declining-balance, the depreciation expense is higher; however, the
company recognizes a gain with the sale of equipment. These different effects of
each method ultimately balance each other out to result in the same €3,173 total
two-year income statement effect.
44
Volvo Group - Research & Development
Costs
Case Study #5
45
Executive Summary
Introduction:
This case contains information regarding the Volvo Group, a company who supplies
commercial vehicles including trucks, buses, construction equipment, engines and drive
systems as well as aircraft engine components. Specifically, this case discusses Volvo’s
treatment of their research and development costs. Headquartered in Torslanda, Sweden,
Volvo Group prepares their financial statements under International Financial Reporting
Standards (IFRS). Indifferent from the U.S. GAAP regulations, the IFRS requires all
research costs to be expensed in the period in which they occur, and allows certain
development expenditures to be classified as intangible assets, and therefore amortized
over a period of time. This case provides information regarding Volvo’s treatment of
R&D under the IFRS guidelines.
Analysis:
Parts A-D of this case pertain to concepts relating to Volvo’s research and development
costs. Volvo’s research and development expenses most likely contain expenditures
relating to achieving technical breakthroughs, reducing the harmful effects of car
emissions, and investments into meeting future emissions and other global emission
regulations. In accordance with the IFRS, Volvo expenses all research expenditures in the
period in which they occur and capitalizes development costs that meet a number of
certifications. Volvo executives must estimate the period of time in which to amortize
development costs using many different sources of information and good judgement.
While the differing treatments of R&D costs mandated by the IFRS and U.S. GAAP both
46
have their advantages and disadvantages, I believe that the IFRS treatment more
accurately matches expenses with their prospective economic benefits. Parts E-G regard
the process Volvo takes in accurately reporting their research and development costs in
their financial statements. Volvo Group reports the development costs that meet the
characteristics to be capitalized in the “Intangible asset” line item of the balance sheet at
their net amount. This net amount is found by subtracting the accumulated amortization
from the total amount of the intangible asset. The percentage of Volvo’s R&D costs that
were capitalized is provided, as well as the proportion of total R&D costs incurred to net
sales for both Volvo Group as well as its U.S. competitor, Navistar International
Corporation.
Conclusion:
This case contains information regarding the different treatments of research and
development costs in accordance with IFRS and U.S. GAAP regulations. The different
treatment of these expenditures under each method is an important aspect to be aware of
when viewing the financial statements of international companies. Learning about the
differences between the IFRS requirements and U.S. GAAP requirements has provided
me with insight into the complexity of accounting for these various expenditures. It has
become evident that there is not a clear, and perfectly justifiable method in which to
account for research and development costs, being that both methods have their
advantages and disadvantages. This case further portrayed the complexity and difficulty
of accounting.
47
The 2009 income statement shows research and development expenses of SEK
13,193 (millions of Swedish Krona). What types of costs are likely included in these
amounts?
Ø Volvo Group’s research and development expenses most likely include activities
focused on achieving new technical breakthroughs, specifically in regard to
reducing the negative environmental impact of car emissions. Volvo Group also
invests research and development into meeting future emissions and other global
emission regulations. Expenditures for the development of new products,
production systems, and software are also included in the company’s research and
development expenses.
Volvo Group follows IAS 38 - Intangible Assets, to account for its research and
development expenditures (see IAS 38 excerpts at the end of this case). As such, the
company capitalizes certain R&D costs and expenses others. What factors does
Volvo Group consider as it decides which R&D costs to capitalize and which to
expense? Volvo Group expenses all of the expenditures arising from the research
portion of research and development; however, they may capitalize intangible assets
arising from the development aspect if, and only if, they demonstrate all of the
following:
Ø The technical feasibility of completing the intangible asset so that it will be
available for use or sale.
Ø Its intention to complete the intangible asset and use or sell it.
48
Ø Its ability to use or sell the intangible asset.
Ø How the intangible asset will generate probable future economic benefits. Among
other things, the entity can demonstrate the existence of a market for the output of
the intangible asset or the intangible asset itself or, if it is to be used internally, the
usefulness of the intangible asset.
Ø The availability of adequate technical, financial and other resources to complete
the development and to use or sell the intangible asset.
Ø Its ability to measure reliably the expenditure attributable to the intangible asset
during its development.
The R&D costs that Volvo Group capitalizes each period (labeled Product and
software development costs) are amortized in subsequent periods, similar to
othercapital assets such as property and equipment. Notes to Volvo’s
financial statementsdisclose that capitalized product and software
development costs are amortized overthree to eight years. What factors
would the company consider in determining theamortization period for
particular costs?
Ø Volvo would need to consider the type of product or software being
developed and, basedon either previous comparable product development
times or reasonable, good faithestimates, approximate a justifiable
amortization period for the particular asset. Volvo mayalso refer to the
49
financial statements of its competitors who may be developing or have
developed similar products in order to estimate a reasonable amortization
period for theparticular product or software being developed.
Under U.S. GAAP, companies must expense all R&D costs. In your opinion,
whichaccounting principle (IFRS or U.S. GAAP) provides financial statements
that betterreflect costs and benefits of periodic R&D spending?
Ø I believe the IFRS guidelines for dealing with R&D costs provide financial
statements thatbetter reflect costs and benefits of periodic R&D spending. If
all R&D costs are expensedwhen incurred as the U.S. GAAP mandates, the
potential benefits of these expenditures arenot properly recognized with
their associated expenses. The IFRS requirement of expensingall research
activities and recognizing development activities as intangible assets better
matches expenses with their associated future revenues. The recognition of
developmentexpenditures as intangible assets is justified because this
phase is further advanced than theresearch phase, therefore more likely to
generate probable future economic benefits.However, the IFRS treatment is
flawed due to the fact that not all development expendituresare associated
with future revenues. Nonetheless, the probability of future economic
benefit is high and can be reasonably estimated in the development stage,
thereforedeserving recognition.
50
Refer to footnote 14 where Volvo reports an intangible asset for “Product and
software development.” Assume that the product and software development
costsreported in footnote 14 are the only R&D costs that Volvo capitalizes.
What is the amount of capitalized product and software development costs,
net of accumulated amortization at the end of fiscal 2009? Which line item on
Volvo Group’s balance sheet reports this intangible asset?
Ø The net amount of product and software development costs is found by
taking thetotal amount of acquisition costs for product and software
development of SEK 25,148, and subtracting its associated accumulated
amortization cost of SEK 13, 739.This yields a final balance of SEK 11, 409
for Volvo’s net amount of 2009 capitalizedproduct and software
development costs. This amount is reported in the “Intangibleassets” line
item of Volvo’s balance sheet.
Create a T-account for the intangible asset “Product and software
development,” net of accumulated amortization. Enter the opening and
endingbalances for fiscal 2009. Show entries in the T-account that record the
2009capitalization (capital expenditures) and amortization. To simplify the
analysis, group all other account activity during the year and report the net
impact as one entry in the T-account.
51
Cap. Product & Software, net (in SEK millions)
Beg Bal 12, 381
AmountsCapitalized 2,602 3,126 Amortization
448 Adjustment
End Bal 11,409
Refer to Volvo’s balance sheet, footnotes, and the eleven-year summary.
Assume thatthe product and software development costs reported in
footnotes 14 are the onlyR&D costs that Volvo capitalizes.Complete the table
below for Volvo’s Product and software development intangibleasset.
(in SEK millions) 2007 2008 2009
1) Product and software development costs capitalizedduring the year
2,057 2,150 1,858
2) Total R&D expense on the income statement
11,059 14,348 13,193
3) Amortization of previously capitalized costs(included in R&D expense)
2,357 2,864 3,126
4) Total R&D costs incurred during the year = 1 + 2 - 3
10,759 13,634 11,925
52
What proportion of Total R&D costs incurred did Volvo Group capitalize (as
product and software development intangible asset) in each of the three
years?
Proportion Capitalized: Product & software development costs capitalized
during the yearTotal R&D costs incurred during the year
2007: 2,057 = 19.12%10,759
2008: 2,150 = 15.77%13,634
2009: 1,858 = 15.58%11,925
Assume that you work as a financial analyst for Volvo Group and would like
tocompare Volvo’s research and development expenditures to the U.S.
competitor,Navistar International Corporation. Navistar follows U.S. GAAP
that requires that allresearch and development costs be expensed in the year
they are incurred. Yougather the following information for Navistar for fiscal
year end October 31, 2007through 2009.
(in US $ millions) 2007 2008 2009
Total R&D costs incurred during the year,expensed on the income statement
375 384 433
Net sales, manufactured products 11,910 14,399 11,300
Total assets 11,448 10,390 10,028
Operating income before tax (73) 191 359
53
Use the information from Volvo’s eleven-year summary to complete the
followingtable.
Calculate the proportion of total research and development costs incurred to
netsales from operations (called, net sales from manufactured products, for
Navistar) forboth firms. How does the proportion compare between the two
companies?
Ø Volvo Group has greater research and development costs than Navistar, as
well as highernet sales for the fiscal years 2007, 2008, and 2009. While
Volvo’s proportion of totalresearch and development costs incurred to net
sales from operations increases over theyears, Navistar’s proportion
decreases from 2007 to 2008, and then increases in thefollowing year.
Regardless, both companies realized a positive proportion for each year.
Volvo Group:
(in SEK millions) 2007 2008 2009
Net sales, industrial operations 276,795 294,932 208,487
Total assets, from balance sheet 321,647 372,419 332,265
2007: 10,759 = 3.89%276,795
2008: 13,634 = 4.62%294,932
2009: 11,925 = 5.72%208,487
54
Navistar:
2007: 375 = 3.15%11,910
2008: 284 = 2.67%14,399
2009: 433 = 4.32%11,300
55
Data Analytics – Microsoft Power BI
Case Study #6
56
Executive Summary Introduction: This case contains information regarding the Microsoft Power BI (Business Intelligence)
software. Officially launched by Microsoft in 2015, Power BI provides a way for
business users to synthesize various forms of big data into easy to understand, visual
formats. These data reports can be stored altogether in one place, updated in real time,
and made available to multiple users on their own devices.
Analysis: The use of Microsoft Power BI would be beneficial in all of the three main areas of
public accounting: auditing, tax planning, and advisory. With auditing, Power BI would
allow auditors to use data presented in various formats to gain a greater understanding of
the client’s business operations, recognize patterns and correlations easier and earlier in
the auditing process, and improve client services. In tax planning, tax professionals
would benefit from the ease of data management and storage offered with Power BI, the
ability to easily transform complex data into understandable visual formats, and be able
to focus more on the insight and foresight of their client’s business rather than just the
hindsight. In the advisory realm, professionals would be able to easily share data reports
with the client, have a heightened awareness of unusual behaviors and risk factors, and
help the client to better understand their analysis and proposed business suggestions.
Overall, the integration of Power BI into essentially all units of business is vital for the
progression of any public accounting firm.
57
Conclusion: This case has broadened my awareness of the increasing importance of data analytics in
the business world today. Data analytics software, such as Microsoft Power BI, are the
key to further business efficiency and productivity. With the increasing importance of
“big data” in analyzing business operations and making important decisions, companies
simply have no other option but to invest in data analytics tools. Data and analytics is the
future of the business world, making it extremely important for individuals to develop a
deeper understanding of these tools and comfort in operating them.
1. Identify the history and purpose of Microsoft Power BI and describe, in
general, how it is used to make business decisions. Be specific about what
kind of technology platform it uses, etc. and other resources that need to be
in place to fully utilize the functionality of the tool.
Ø Microsoft Power BI (Business Intelligence) was originally created by
Amir Netz of the SQL Server Reporting Services Team at Microsoft in
2006. Originally, the development of this new software was kept a secret
under the code name “Gemini.” In 2009, “Gemini” was renamed “Power
Pivot” and released as a free Microsoft Excel add-in. As Power Pivot
began to gain popularity, Microsoft began to invest more into it,
eventually releasing it as part of SharePoint—Microsoft’s document
management and storage system software—in 2012. In 2013, Microsoft
launched “Power Query,” a data reshaping and combining tool, as an
additional Excel add-in. While Power Pivot and Power Query were
58
extremely accessible as Excel add-ins, they did not offer a way for the data
to be easily shared with others. In response to this problem, Microsoft
introduced the Power BI service in 2015, combining the benefits of Power
Pivot and SharePoint into one single application. Power BI provides a way
for business users to synthesize various forms of data into easy to
understand, visual formats. This data can be stored altogether in one place,
updated in real time, and made available to multiple users on their own
devices. Power BI makes business decisions simpler by providing a
multitude of various data in one simple, concise formation, making it
easier for individuals to access and analyze. Reports made through
Microsoft BI can be securely published for organizations to access through
the web or on a mobile device with the Power BI Mobile app.
2. What special skills are needed to use Power BI to aid in business decision
making. How might a student like yourself gain those skills?
Ø Unlike previous, more traditional BI systems, Microsoft Power BI takes
the process of data combination and report building to a whole new level
of simplicity. While the traditional model for building a report containing
a multitude of various data sources would require the assistance of a
technical specialist or IT department, Power BI makes this process
attainable for any individual containing basic Excel skills. Users are given
the ability to easily connect to any data source and quickly summarize
findings into a simple, accessible report without the complexity and hassle
of programming. Any business user comfortable with building Excel
models that reference multiple sheets or conducting advanced Excel
59
functions will have great success in using Power BI for decision making.
While not many students possess the technical skills necessary to create a
summarized data report using the traditional systems, Power BI makes it
possible for students with basic Excel knowledge to build an impressive
data report.
3. How, specifically, would you use Power BI in the following business settings?
Create at least three specific scenarios for each category in which Power BI
would lead to more efficiency and/or better effectiveness. Be sure to describe
what kinds of data Power BI would use for each scenario.
Ø Auditing
i. Use of Multiple Data Formats: For auditors, it is extremely
important to utilize all types of data generated from a client’s
business activities. While auditors have access to a multitude of
relevant data information from their client, it can be complicated
for this data to be successfully analyzed and compared being that it
may be available in a multitude of various formats (i.e. audio,
image, video). However, with the use of data analytics applications
such as Power BI, auditors now have the ability to successfully
consolidate, analyze, and compare various forms of data. For
example, Power BI offers the ability to combine data pertaining to
sales calls made to customers with revenue numbers to provide a
more complete basis for the analysis of the client’s sales. The use
of Power BI throughout the audit process would lead to a more
precise and complete audit.
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ii. Pattern Recognition: Power BI offers the ability for big data to be
consolidated all in one place, with easy accessibility for all users.
Power BI also allows data to be updated in real time. These
functions would be extremely beneficial to the audit process due to
the large amount of data that must be analyzed by auditors. It is
important for auditors to possess a sufficient understanding of a
client’s business in order to be able to recognize suspicious
activity, assess risk, and identify fraudulent activities. This can be
done through the recognition and knowledge of patterns and trends
found through data analysis. Power BI’s accessibility, ability to
compile big data, and visual formatting would make the
recognition of patterns, correlations, and fluctuations from these
findings easier for auditors to analyze.
iii. Improved Client Service: Not only can the implementation of
Power BI positively affect the auditors themselves, this software
would also enhance the client’s experience throughout the audit
process. With Power BI, the recognition of patterns, correlations,
and suspicious deviations from the model would be easier to
analyze, therefore providing auditors with the opportunity to
communicate any concerns with the client at an earlier date. This
allows for the client to be more proactive with their responsive
actions. Power BI would also enhance client communication, being
that data can be visualized in simple, understandable formats,
providing an opportunity for the client to analyze and digest the
61
data as well. Client’s would be given the opportunity to visualize
their everyday data in new ways, enabling an opportunity for them
to understand their information from a different perspective.
Ø Tax Planning
i. Data Management: Tax is one of the largest consumers of data.
This extensive amount of available data can present a challenge for
tax professionals when attempting to consolidate, compare, and
analyze this big data. This challenge makes tax planning a prime
candidate for the use of data analytics tools, such as Power BI.
Power BI offers the ability to consolidate structured data—data
presented in a field or in tables—with the more complicated,
unstructured data—various data such as vendor invoices, tax
legislation, and other text documents. Without the use of data
analytics, this function would be an extremely difficult and time-
consuming process. Power BI also makes the combination of
internal data and external data possible, and easier than ever. Using
the Power BI gateways, users can connect SQL Server databases,
Analysis Services models, and many other data sources to the same
dashboard in Power BI. With the use of Power BI, tax
professionals can manage the extensive amount of various data all
in one place updated in real time, making the analysis of this data
and recognition of patterns and correlations much easier.
ii. Visualization: The visualization of data in charts, diagrams, fields,
and tables can allow for the data to be viewed from different
62
perspectives and explained in different ways. Visualization aids in
narrowing the focus down to the key issues driving the client’s tax
liability. With access to a library of custom visualizations, Power
BI Desktop allows productivity and creativity when arranging data
into visual formats. Visualization also allows for easier
communication of data interpretations between the tax
professionals and the client. With Power BI, the client no longer
has to flip through complex spreadsheets or navigate multiple data
sources. Power BI Desktop allows all data to be stored in one place
and possesses the ability to be accessed by multiple people on
multiple devices. This data is also updated in real time, making it
simple for tax professionals to reconstruct or change data
presentations without having to redistribute the data to the client.
iii. Hindsight, Insight, Foresight: Traditionally, tax planning has
focused on hindsight, dealing with data that has already occurred.
While the hindsight focus still remains necessary for successful tax
planning, data and analytics tool such as Power BI are now
allowing for a greater focus on the insight and foresight aspects of
tax planning. Essentially, data and analytics changes the tax
professional’s mindset of “What do I need to do?” to “What do I
need to know?” With Power BI gateways, data can be queried into
large datasets and programmed to automatically refresh, giving
analysts the most up to date data possible. These tools allow for a
deeper insight and understanding of the drivers of the client’s tax
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liability. This deeper insight provides the means for a more
complete and accurate foresight, even in the absence of future data.
With Power BI’s ability to consolidate various forms of data from
different sources all to one place, it is easier for tax professionals
to build future models based on previous trends and correlations.
For example, monthly trends in book income, cash taxes, and
effective tax rates can help reduce the potential for future tax
related surprises.
Ø Financial Statement Analysis / Valuation / Advisory
i. Simple Sharing: With other data analytics tools, it can be a hassle
to distribute and share information with the client. With Excel,
sharing is limited by the cumbersome nature of having to email
large data sets. With other business intelligence software, data
sharing can be limited by extremely expensive software licensing.
With Power BI, users have the ability to publish and embed live
data reports in any web page. This function is a huge advantage for
the advisory realm being that it offers professionals the ability to
reconfigure data sets to exhibit different scenarios right in front of
the client. The days of professionals having to reconfigure the data
to exhibit a certain business scenario and then go through the
cumbersome process of redistributing this data to the client are
long gone with the use of Power BI. This open access between the
advisory professional and the client creates an interactive
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relationship between the two, ultimately leading to more intelligent
business decisions.
ii. Risk Consulting: As previously discussed, Power BI makes the
awareness of patterns and correlations easier for users to recognize
and analyze. With the ability to easily combine multiple forms of
data (i.e. structured, unstructured, internal, external) all in one
place, users are able to compare a plethora of business transactions
to arrive at key observations. The recognition of these patterns and
correlations allow for the creation of a model of the client’s regular
business functions. This model then provides for an easier
detection of suspicious activity and helps professionals generate a
clearer view of the client’s risk factors.
iii. Client Understanding: Power BI provides a way for advisory
professionals to present data to a client in a clear, easy to
understand visual format. Instead of professionals simply stating
their advice to a client based on analysis that they have made
themselves, Power BI allows for extensive interactivity between
the consultant and the client. The client gains a greater
understanding of their business, as well as a complete understand
of the consultant’s business suggestions with the use of Power BI.
Together, with the assistance of Power BI, consultants and clients
can partake in a more complete analysis and arrive at more
confident, evidence based solutions.
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4. Write a few paragraphs to your future public accounting partner explaining
why your team should invest in the acquisition of and training in this tool.
Explain how the tool will impact the staffing and scope of your future
engagements.
Ø Investing in Microsoft Power BI would be a huge asset for all sections of
our business. Power BI offers the ability to consolidate big data from
multiple data sources all in one place using the gateway feature, and then
allows for feature-rich data mashup and creative, productive visualization
formats using Power BI Desktop. With this business intelligence software,
our team would be able to compare a multitude of dissimilar data, such as
unstructured/structured data and internal/external data in order to arrive at
insightful realizations and suggestions. The ability to combine such a large
amount of data and make comparisons between data of various formats
would allow for our team to recognize patters and correlations earlier in
the analysis process. Unlike more traditional business intelligence
software, Power BI does not require extensive IT knowledge. Power BI
can be used by any individual who possesses basic Excel knowledge and
skills. Therefore, there would be no need for extensive training on this
software. With Power BI, gone are the days of relying on IT specialists to
create big data presentations. Now, all team members have the ability to
work with big data, aiding in the efficiency and productivity of our team.
Not only would our team members benefit directly from the integration of
this software, our clients would reap the benefits of this business
intelligence application as well. Power BI offers the ability to publish data
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sets to the web, therefore providing easy access for the client to view data
reports. These data reports can also be programmed to automatically
refresh when changes are made, therefore eliminating the cumbersome
process of having to redistribute data to clients every time changes are
made. Power BI makes the presentation of complex data simple and
understandable, therefore allowing the client to analyze and understand the
presented data with ease. The integration of Power BI into our team’s
daily business functions is vital to the future success of our company.
Works Cited
“8 Facts about Power BI You Should Know.” InfoWorks, 26 Feb. 2016.
Mueller, Beth, and Nathan Andrews. “Tax Data Analytics.” Deloitte United States, 12
Nov. 2017.
Tang, Jail, and Khondkar E. Karim. “Big Data in Business Analytics: Implications for the
Audit Profession.” The CPA Journal, 22 June 2017.
Tim Rodman. “What Is Power BI?” Tim Rodman, 21 May 2016.
“What Is Power BI?” What Is Power BI | Microsoft Power BI, Microsoft.
67
Rite Aid Corporation – Long Term
Debt
Case Study #7
68
Executive Summary
Introduction:
With 4,780 stores in 31 states, Rite Aid is the third largest retail pharmacy in the U.S.
Rite Aid Corporation sells are wide variety of over-the-counter-medications, health and
beauty products, household items, beverages, convenience food, greeting cards, seasonal
merchandise, and photo processing in addition to pharmacy prescriptions. Due to the
large nature of this corporation, it is necessary for Rite Aid to finance its operations
heavily with debt. Rite Aid finances its operations with a wide variety of debt including
secured debt, unsecured unguaranteed debt, and guaranteed unsecured debt. These
various forms of debt constitute a wide variety of interest rates and credit terms. This case
focuses on analyzing Rite Aid’s various forms of debt and its effect on Rite Aid’s assets,
liabilities, and net income.
Analysis:
Part A of this case contains definitions and explanations of Rite Aid’s various debt
instruments. It is explained that Rite Aid’s secured debt differs from its unsecured debt
due to the company’s right to collateral with secured debt. This collateral, usually found
in the form of assets, may be collected by Rite Aid if the debt arrangement is not satisfied
by the debtor. Of Rite Aid’s unsecured debt, some contain guarantees by Rite Aid’s
wholly-owned subsidiaries. If these guaranteed unsecured debt arrangements are not
satisfied, Rite Aid’s subsidiaries will cover either all or a partial amount of the debt
obligation. The important terms pertaining to debt “senior,” “fixed rate,” and
“convertible” are also defined and explained in this section of the case. Due to the size of
Rite Aid Corporation, it is necessary for Rite Aid to take part in several forms of debt
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financing in order to fund its operations and expansion ventures. Parts B, C, and D focus
on the analysis of Rite Aid’s debt. Rite Aid’s total debt and the portion this total debt
representing current obligations is calculated in Part B. Part C focuses on the 7.5%
senior secured notes due March 2017. The face value, interest payments, and journal
entries dealing with these notes are calculated. Part D analyzes the 9.375% notes due
December 2015. Because these notes were issued at a discount, the total interest expense
includes a cash interest payment as well as a non-cash interest payment. The non-cash
part of interest expense represents the amortization of the discount on the notes. Part E
focuses on the 9.75% notes due June 2016. Similar calculations are presented along with
an amortization schedule for the notes.
Conclusion:
This case provides information and analysis proving the complexity of debt in a large
corporation. Large corporations, such as Rite Aid, finance their operations through
various forms of debt such as secured debt, guaranteed unsecured debt, and unsecured
unguaranteed debt. These debt instruments all contain different terms, face values, and
interest rates. It is important for Rite Aid to establish adequate debt management in order
to ensure that the corporation is benefiting from its debt financing.
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a. Consider the various types of debt described in note 11, Indebtedness and
Credit Agreement.
i. Explain the difference between Rite Aid’s secured and unsecured
debt. Why does Rite Aid distinguish between these two types of debt?
Ø Rite Aid’s secured debt is backed by an asset referred to as collateral. If
the debtor fails to satisfy the terms of the debt, Rite Aid may claim the
collateral used to guarantee the loan. Rite Aid’s unsecured debt is not
backed by collateral; therefore, Rite Aid does not have any ownership
claim against the debtor if they fail to satisfy the terms of the debt
agreement. Rite Aid distinguishes between these two forms of debt
because it is important information for investors and creditors to know
when viewing Rite Aid’s financial statements.
ii. What does it mean for debt to be “guaranteed”? According to note
11, who has provided the guarantee for some of Rite Aid’s unsecured
debt?
Ø Guaranteed debt occurs when one party (the guarantor) makes a promise
to assume the debt obligation of a borrower if that borrower fails to satisfy
the debt obligation. A guarantee can be limited or unlimited, meaning
they are either responsible for all of the debt or just a portion of the debt.
Substantially all of Rite Aid Corporation’s wholly-owned subsidiaries
have provided the guarantee for some of Rite Aid’s unsecured debt.
iii. What is meant by the terms “senior,” “fixed-rate,” and “convertible”?
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Ø The term “senior” refers to debt that takes priority over other unsecured
debt owned by the issuer. The senior debt has priority for repayment in
the case of liquidation. “Fixed rate” refers to a fixed, predetermined
interest rate associated with a debt instrument. The term “convertible”
refers to a bond or other various forms of debt that gives the holder the
option to convert the debt into a specified number of shares of common
stock in the issuing company.
iv. Speculate as to why Rite Aid has many different types of debt with a
range of interest rates.
Ø Being that Rite Aid Corporation is an extremely large corporation and
requires a large amount of capital, it is necessary for Rite Aid to fund its
operations through various forms of debt with a broad range of interest
rates.
b. Consider note 11, Indebtedness and Credit Agreement. How much total debt
does Rite Aid have at February 27, 2010? How much of this is due within the
coming fiscal year? Reconcile the total debt reported in note 11 with what
Rite Aid reports on its balance sheet.
Ø At February 27, 2010, Rite Aid has total debt of $6,370,899. Of this total
debt, $51,502 is due within the coming fiscal year.
c. Consider the 7.5% senior secured notes due March 2017.
i. What is the face value (i.e. the principle) of these notes? How do you
know?
Ø The face value of these notes is $500,000. Because the carrying value for
2009 and 2010 is $500,000, the notes must have been issued at their
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principle of $500,000. This means that the notes were not issued at a
premium or a discount, therefore there is no change in the notes’ carrying
value from year to year.
ii. Prepare the journal entry that Rite Aid must have made when these
notes were issued.
Cash 500,000 Notes Payable 500,000
(Assets à Increase, Liabilities à Increase, Net Income à Not effected)
iii. Prepare the annual interest expense journal entry. Note that the
interest paid on a note during the year equals the face value of the
note times the state rate (i.e., coupon rate) of the note.
Interest Expense 37,500 Cash 37,500
(Assets à Decrease, Liabilities à No effect, Net Income à Decrease)
iv. Prepare the journal entry that Rite Aid will make when these notes
mature in 2017.
Notes Payable 500,000 Cash 500,000
(Assets à Decrease, Liabilities à Decrease, Net Income à No effect)
d. Consider the 9.375% senior note due December 2015. Assume that interest is
paid annually.
i. What is the face value (or principle) of these notes? What is the
carrying value (net book value) of these notes at February 27, 2010?
Why do these two values differ?
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Ø The face value of these notes is $410,000. The carrying value of these
notes at February 27, 2010 is $405,951. These two values differ due to the
amortization of $4,049 of the total discount on the notes.
ii. How much interest did Rite Aid pay on these notes during the fiscal
2009?
Ø Rite Aid made a cash interest payment of $38,438 on these notes during
fiscal 2009.
iii. Determine the total amount of interest expense recorded by Rite Aid
on these notes for the year ended February 27, 2010. Note that there
is a cash and a noncash portion of interest expense on these notes
because they were issued at a discount. The noncash portion of
interest expense is the amortization of the discount during the year
(that is, the amount by which the discount decreased during the year).
Ø The total amount of interest expense recorded by Rite Aid on these notes
for the year ended February 27, 2010 was $39,143. The cash portion of
this interest expense was $38,438, and the noncash (amortized discount)
portion was $705.
iv. Prepare the journal entry to record interest expense on these notes for
fiscal 2009. Consider both the cash and discount (noncash) portions
of interest expense from part iii above.
Interest Expense 39,143 Discount on Notes Payable
705
Cash 38,438
(Assets à Decrease, Liabilities à Increase, Net Income à Decrease)
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v. Compute the total rate of interest recorded for fiscal 2009 on these
notes.
Ø The effective interest rate for these notes is 9.659%, and the stated interest
rate is 9.375%.
e. Consider the 9.75% notes due June 2016. Assume that Rite Aid issued these
notes on June 30, 2009 and the company pays interest on June 30th of each
year.
i. According to note 11, the proceeds of the notes at the time of issue
were 98.2% of the face value of the notes. Prepare the journal entry
that Rite Aid must have made when these notes were issued.
Cash 402,620 Discount on Notes Payable 7,380 Notes Payable 410,000
(Assets à Increase, Liabilities à Increase, Net Income à No effect)
ii. At what effective annual rate of interest were these notes issued?
Ø The note was issued at an effective annual interest rate of 10.1212%.
iii. Assume that Rite Aid uses the effective interest rate method to
account for this debt. Use the table that follows to prepare an
amortization schedule for these notes. Use the last column to verify
that each year’s interest expense reflects the same interest rate even
though the expense changes. Note: Guidance follows the table.
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Date Interest Payment
Interest Expense
Bond Discount Amortization
Net Book Value of Debt
Effective Interest Rate
June 30, 2009 -- -- -- $ 402,620 10.1212 %
June 30, 2010 $ 39,975 $ 40,750 $ 775 $ 403,395 10.1212 %
June 30, 2011 $ 39,975 $ 40,828 $ 853 $ 404,248 10.1212 %
June 30, 2012 $ 39,975 $ 40,915 $ 940 $ 405,188 10.1212 %
June 30, 2013 $ 39,975 $ 41,010 $ 1035 $ 406,223 10.1212 %
June 30, 2014 $ 39,975 $ 41,115 $ 1140 $ 407,363 10.1212 %
June 30, 2015 $ 39,975 $ 41,230 $ 1255 $ 408,618 10.1212 %
June 30, 2016 $ 39,975 $ 41,357 $ 1382 $ 410,000 10.1212 %
iv. Based on the above information, prepare the journal entry that Rite
Aid would have recorded February 27, 2010, to accrue interest
expense on these notes.
Interest Expense 27,167 Discount on Notes Payable 517 Interest Payable 26,650
Assets à No Effect, Liabilities à Increase, Net Income à Decrease)
v. Based on your answer to part iv., what would be the net book value of
the notes at February 27, 2010?
The net book value (i.e., carrying value) at February 27, 2010 would be
$403,137.
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Merck & Co., Inc.—Shareholders’ Equity
Case Study #8
77
Executive Summary
Introduction:
Headquartered in New Jersey, Merck & Co. is a global research-driven
pharmaceutical company that discovers, develops, manufactures, and markets a
broad range of products aimed at the improvement of human and animal health.
Merck has a large number of employees from across the globe, with the majority
of them having an engagement in research activities. Merck’s shares are sold on
the New York and Philadelphia Stock Exchanges. This case provides analysis of
the equity section of Merck’s balance sheet.
Analysis:
This particular case consists of the analysis of Merck’s equity. Part 1 of this case
pertains specifically to Merck’s common shares. In the stockholders’ equity
section of Merck’s balance sheet, the number of total shares Merck is authorized
to sell and the number of issued shares are both listed as separate line items. The
ability to differentiate between Merck’s authorized and issued shares is important
for financial statement users and potential investors. Furthermore, it is vital for
investors and creditors to note the portion of Merck’s issued shares that are
currently being held by the company as treasury stock. This can be calculated by
subtracting Merck’s treasury stock (found at the bottom of the equity section of
Merck’s balance sheet) from the number of issued shares for that year. Merck’s
market capitalization can be found by multiplying the number of shares
outstanding (shares actually owned by the company’s shareholders) by the market
price per share of the company’s stock at that date. This is an important area of
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analysis for financial statement users because it represents the total dollar value of
the company that is currently being traded on the stock market. Part 2 deals with
Merck’s payment of dividends and their reasoning behind these payments.
Companies choose to distribute dividends when their earnings allow as a way to
communicate strength and profitability to their shareholders. The payment of
dividends makes the stock more attractive in the eyes of shareholders, therefore
increasing a company’s share price. Part 3 explains the reason why companies
often partake in the buyback of their own stock. Companies buy their own shares
of stock on the market as a way of investing in their own company. The purchase
of treasury stock could indicate the company’s confidence in future profitability,
as well as reduce the number of shares outstanding. The reduction of shares
outstanding boosts a company’s earnings per share, therefore potentially
increasing the value of its stock. Part 4 presents the journal entry made by Merck
for the payment of dividends distributed in 2007. Part 5 analyzes Merck’s treasury
stock transactions for 2007 through the analysis of Merck’s statement of cash
flows. Finally, Part 6 consists of a chart with information pertaining to Merck’s
equity, as well as certain relevant financial statement ratios.
Conclusion:
This case presents the importance and complex nature of the stockholder’s equity
section of the balance sheet.
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1. Consider Merck’s common shares.
i. How many common shares is Merck authorized to issue?
Ø Merck is authorized to issue 5,400,000 shares of common stock.
ii. How many common shares has Merck actually issued at December 31,
2007?
Ø At December 31, 2007, Merck has actually issued 2,983,508,6675 shares
of common stock.
iii. Reconcile the number of shares issued at December 31, 2007, to the
dollar value of common stock reported on the balance sheet.
Ø The dollar value of common stock reported on the balance sheet represents
the par value of Merck’s common stock. Therefore, one can conclude the
par value of common stock to be $0.01 per share. Merck’s issued shares of
2,983,508,675 multiplied by the par value of $0.01, gives the dollar value
of the stock—29.8 million—that is reported on Merck’s balance sheet.
iv. How many common shares are held in treasury at December 31,
2007?
Ø Merck has 811,005,791 common shares held in treasury as of December
31, 2007.
v. How many common shares are outstanding at December 31, 2007?
Ø To calculate the number of Merck’s common shares outstanding at
December 31, 2007, one subtracts the shares held in treasury from the total
number of common shares issued. This gives the number of common
shares actually held by the company’s shareholders, representing Merck’s
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outstanding common stock. Merck has common shares of 2,172,502,884
outstanding at December 31, 2007.
vi. At December 31, 2007, Merck’s stock price closed at $57.61 per share.
Calculate the total market capitalization of Merck on that day.
Ø A company’s total market capitalization can be calculated by multiplying
the number of shares outstanding by the market price per share on the
current date. Merck had 2,172,502,884 shares outstanding at December
31, 2007 and a market price per share of $57.61. Therefore, Merck’s
market capitalization at that date would be $125,157,891,100.
2. Why do companies pay dividends on their common or ordinary shares?
What normally happens to a company’s share price when dividends are
paid?
Ø Companies pay dividends on their common or ordinary shares in order to
provide shareholders with confidence in the company’s strength and
profitability. The distribution of dividends is also a positive sign of future
earnings, therefore making the company’s stock more attractive in the
eyes of shareholders. A company’s share price usually increases with the
payment of dividends.
3. In general, why do companies repurchase their own shares?
Ø In general, a company will repurchase its own shares of stock as a means
of investing in itself. When a company repurchases its own stock, the
shares are absorbed by the company therefore reducing the number of
shares outstanding. The reduction of outstanding shares increases the
relative ownership stake of each shareholder, therefore improving the
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company’s earnings per share. This leads to more attractive stock in the
eyes of shareholders.
4. Consider Merck’s statement of cash flows and statement of retained
earnings. Prepare a single journal entry that summarizes Merck’s common
dividend activity for 2007.
Retained Earnings 3310.7 Dividends Payable 3307.3 Cash 3.4
5. During 2007, Merck repurchased a number of its own common shares on the
open market.
i. Describe the method Merck uses to account for its treasury stock
transactions.
Ø As described in Note 11, Merck uses the cost method when accounting for
treasury stock transactions.
ii. Refer to note 11 to Merck’s financial statements. How many shares
did Merck repurchase on the open market during 2007?
Ø Merck repurchased 26.5 million shares of treasury stock on the open
market during 2007.
iii. How much did Merck pay, in total and per share, on average, to buy
back its stock during 2007? What type of cash flow does this
represent?
Ø Merck paid $1,429.7 million to buy back 26.5 million shares of its
common stock during 2007. Therefore, Merck paid $53.95 per share.
These purchases represent a cash outflow from financing activities, and is
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accounted for in the line item “purchases of treasury stock” in the
financing section of Merck’s statement of cash flows.
iv. Why doesn’t Merck disclose its treasury stock as an asset?
Ø Treasury stock is not considered to be an asset. Treasury stock is
accounted for as a contra equity account; therefore, it is subtracted from
Merck’s equity section on the balance sheet.
6. Determine the missing amounts and calculate the ratios in the tables below.
For comparability, use dividends paid for both companies rather than
dividends declared. Use the number of shares outstanding at year end for
per-share calculations. What differences do you observe in the two
companies’ dividend-related ratios?
2007 2006
Dividends paid 3,307.3 3,322.6
Shares outstanding 2,172.5 2,167.8
Net income 3,275.4 4,433.8
Total assets 48,350.7 44,569.8
Operating cash flows 6,999.2 6,765.2
Year-end stock price $57.61 $41.94
Dividends per share $1.52 $1.53
Dividend yield 2.64% 3.65%
Dividend payout 1.01 .749
Dividends to total assets 6.84% 7.45%
Dividends to CF 47.25% 49.11%
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State Street Corporation—Marketable Securities
Case Study #9
84
Executive Summary
Introduction:
State Street Corporation operates primarily through its principal banking subsidiary, State
Street Bank and Trust, with a focus on serving institutional investors. State Street’s two
lines of business consist of Investment Servicing and Investment Management. Products
of State Street Corporation include brokerage and other trading services, securities
finance, deposit and short-term investment facilities, performance, risk and investment
research, and investment management. This case focuses on State Street’s marketable
securities and the differences between trading, available-for-sale, and held-to-maturity
securities. The ways in which State Street accounts for and values these various securities
on their financial statements is discussed throughout this case.
Analysis:
Parts A, B and C of this case focus on differentiating between the various types of
marketable securities that State Street possesses. These securities consist of trading
securities, available-for-sale securities, and held-to-maturity securities. Part A discusses
trading securities, securities in which management intends to sell within a short period of
time (usually within a year). These securities are valued at their fair value on the balance
sheet, and are reported as current assets. The unrealized holding gains and losses related
to the change in fair value flow through the company’s income statement. Part B
discusses available-for-sale securities, a classification given to securities that neither
classify as trading or held-to-maturity securities. Management’s intent for these securities
is unclear. Available-for-sale securities are valued at their fair value, with unrealized
holding gains and losses recorded in other comprehensive income (equity) on the balance
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sheet. Part C discusses held-to-maturity securities, securities in which management
intends to hold until their stated maturity date. These securities are valued at amortized
cost, and no adjustment is made for any changes in their fair value. The only gains or
losses recorded for held-to-maturity securities are realized gains or losses resulting from
the sale of the securities at their maturity date. Because equity securities do not have a
maturity date, only debt securities may be classified as held-to-maturity. Parts E-G focus
on the specific balances presented for these various securities on State Street’s financial
statements.
Conclusion:
This case shows the importance of the different valuation methods for trading, available-
for-sale, and held-to-maturity securities and the ways in which the accounting for these
securities ultimately effects the financial statements. Not only is it important for
companies to guarantee they are accounting for these securities in the proper manner, it is
also essential for financial statement users to recognize and understand the different
valuation methods for these securities.
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a. Consider trading securities. Note that financial institutions such as State
Street typically call these securities “Trading account assets.”
i. In general, what are trading securities?
Ø Trading securities are either debt or equity securities in which the
company intends to sell within a short period of time, usually less than a
year. These securities are classified as current assets on the balance sheet.
ii. How would a company record $1 of dividends or interest received
from trading securities?
The journal entry to record $1 of dividend revenue:
Cash 1 Dividend Revenue 1
The journal entry to record $1 of interest received:
Cash 1 Interest Revenue 1
iii. If the market value of trading securities increased by $1 during the
reporting period, what journal entry would the company record?
Fair Value Adjustment - Trading 1 Unrealized Holding Gain - Inc 1
b. Consider securities available-for-sale. Note that State Street calls these,
“Investment securities available for sale.”
i. In general, what are securities available-for-sale?
Ø Available-for-sale securities are either debt or equity securities in which
management’s intent is unclear as to whether they plan to sell the
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securities or hold them to maturity. The “available-for-sale” classification
is applied to securities that cannot be classified as either a trading security
or held-to-maturity security.
ii. How would a company record $1 of dividends or interest received
from securities available-for-sale?
The journal entry to record $1 of dividend revenue:
Cash 1 Dividend Revenue 1
The journal entry to record $1 of interest received:
Cash 1 Interest Revenue 1
iii. If the market value of securities available-for-sale increased by $1
during the reporting period, what journal entry would the company
record?
Fair Value Adjustment – AFS 1 Unrealized Holding Gain 1
c. Consider securities held-to-maturity. Note that State Street calls these,
“Investment securities held-to-maturity.”
i. In general, what are these securities? Why are equity securities never
classified as held-to-maturity?
Ø Securities classified as held-to-maturity are debt securities in which
management intends to hold until their stated maturity date. Equity
securities are never classified as held-to-maturity being that they do not
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have a stated maturity date. These securities are valued at their amortized
cost on the balance sheet.
ii. If the market value of securities held-to-maturity increased by $1
during the reporting period, what journal entry would the company
record?
Ø Because it is management’s intent to hold these securities until maturity,
the changes in fair value are not recorded. Held-to-maturity securities are
valued at their amortized cost on the balance sheet; therefore, there would
be no entry made for the increase in fair value.
d. Consider the “Trading account assets” on State Street’s balance sheet.
i. What is the balance in this account on December 31, 2012? What is
the market value of these securities on that date?
Ø The balance in the “Trading account assets” account on December 31,
2012 is $637,000,000. Being that these trading securities are valued at
their fair value, it is safe to assume that the market value of these
securities is $637,000,000 as well.
ii. Assume that the 2012 unadjusted trial balance for trading account
assets was $552 million. What adjusting journal entry would State
Street make to adjust this account to market value? Ignore any
income tax effects for this part.
Trading Account Assets 85 Trading Services 85
*shown in millions
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e. Consider the balance sheet account “Investment securities held to maturity”
and the related disclosures in Note 4.
i. What is the 2012 year-end balance in this account?
Ø The 2012 year-end balance in the “Investment securities held to maturity”
account is $11,379,000,000.
ii. What is the market value of State Street’s investment securities held
to maturity?
Ø The market value for State Street’s held-to-maturity securities, as stated in
Note 4, is $11,661,000,000. This proves there to be a material difference
between the amortized cost of the securities and their current market
value. Being that the market value exceeds the amortized cost, one can
assume that the value of these securities has increased.
iii. What is the amortized cost of these securities? What does “amortized
cost” represent? What does the difference suggest about how the
average market rate of interest on held-to-maturity securities has
changed since the purchase of the securities held by State Street?
Ø The amortized cost of State Street’s held-to-maturity securities is
$11,379,000,000. This value represents the original acquisition price of
the securities and any unamortized discount or premium to date. If the
securities were purchased at a discount, the discount amortization would
increase the securities’ value over their life. On the other hand, if the
securities were purchased at a premium, the amortization would decrease
the securities’ value. The difference between the amortized cost of
$11,379,000,000 and market value of $11,661,000,000 reveals an increase
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in the securities’ value over time. This increase reflects a decrease in the
securities’ market interest rate below the stated rate. As the market rate
decreases, the securities become more valuable to investors.
f. Consider the balance sheet account “Investment securities available for sale”
and the related disclosures in Note 4.
i. What is the 2012 year-end balance in this account? What does this
balance represent?
Ø The 2012 year-end balance for the “Investment securities available for
sale” account is $109,682,000,000. This value represents the securities’
fair market value.
ii. What is the amount of net unrealized gains or losses on the available-
for-sale securities held by State Street at December 31, 2012? Be sure
to note whether the amount is a net gain or loss.
Ø Through the netting of unrealized gains and losses recorded for the
available-for-sale securities throughout the year, a net unrealized gain of
$1,119,000,000 is calculated.
iii. What was the amount of net realized gains (losses) from sales of
available-for-sale securities for 2012? How would this amount impact
State Street’s statements of income and cash flows for 2012?
Ø As presented on State Street’s income statement, there is a realized gain of
$55,000,000 from the sale of available-for-sale securities. If the statement
of cash flows for this company were given, this amount would appear as a
positive cash flow under the “cash flows from operating activities”
section.
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g. State Street’s statement of cash flow for 2012 (not included) shows the
following line items in the “Investing Activities” section relating to available-
for-sale securities (in millions):
Proceeds from sales of available-for sale securities $5,399
Purchases of available-for-sale securities $60,812
i. Show the journal entry State Street made to record the purchase of
available-for-sale securities for 2012.
Investments in AFS Securities 60,812 Cash 60,812
*shown in millions
ii. Show the journal entry State Street made to record the sale of
available-for-sale securities for 2012. Note 13 (not included) reports
that available-for-sale securities sold during 2012 had “unrealized pre-
tax gains of $67 million as of December 31, 2011.” Hint: be sure to
remove the current book-value of these securities in your entry.
Cash 5,399 Unrealized Holding Gain 67 Investments in AFS Securities 5,411 Gain on Sale of AFS Securities 55
*shown in millions
iii. Use the information in part g.ii to determine the original cost of the
available-for-sale securities sold during 2012.
Ø The original cost of the available-for-sale securities sold in 2012 can be
calculated by subtracting the realized gain from the sale of these securities
from the cash proceeds of the sale. This results in a book value of
$5,344,000,000 for the available-for-sale securities.
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ZAAG Inc.—Deferred Income Taxes
Case Study #10
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Executive Summary
Introduction:
ZAGG, “Zealous About Great Gadgets,” began business designing and protecting plastic
shields for wristwatches in 2005. ZAGG also manufactures products such as mobile
keyboards, cases, headphones, and portable power devices. This case analyzes the
concepts underlying deferred income tax accounting. Concepts relating to book income,
taxable income, permanent and temporary tax differences, statutory and effective tax
rates, deferred tax liabilities, deferred tax assets, and deferred tax valuation accounts are
discussed and explained. Analysis of ZAGG’s specific accounting for their deferred tax
assets and liabilities is also included in this case.
Analysis:
Due to the various differences in GAAP accounting as opposed to the IRS tax code rules,
company’s pre-tax financial income—or book income—differs from the amount in which
they report as taxable income on its tax return. These differences are either classified as
temporary or permanent tax differences. Permanent differences result from transactions
that are either included in book income but not taxable income, or included in taxable
income but not book income. Permanent differences are not reversed in future years.
Temporary differences are the result of timing differences in the inclusion of certain
transactions in book income and taxable income. Temporary differences may result from
an item being included in book income for the current year but not taxable income, or
vice versa. Temporary differences result in either a deferred tax liability or a deferred tax
asset. Deferred tax assets arise from deductible temporary differences. A company pays
tax on an item in a current year, and is able to deduct that amount in a future year,
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resulting in a deferred tax asset. While deferred tax assets may sound favorable, they are
actually unfavorable to the tax payer. Deferred tax liabilities arise from taxable temporary
differences. A company is able to deduct an item from its taxable income in the current
year, therefore deferring the payment of tax to a future year. Because tax payers always
prefer to push back tax liabilities as far in the future as possible, deferred tax liabilities
are favorable. If a company can reasonably assume that they will not realize some or all
of a deferred tax asset, they may use a deferred tax valuation allowance account. This
account is evaluated at the end of the year, and serves as a contra deferred tax asset
account; therefore, decreasing the value of the deferred tax asset. Part f refers specifically
to ZAGG’s accounting treatment regarding its deferred tax assets and liabilities.
Conclusion:
Accounting for the differences in book income and taxable income and dealing with
deferred tax assets and deferred tax liabilities is crucial. If a company fails to properly
account for these items, it could find itself committing tax evasion or failing to take
advantage of tax savings. As a financial statement user, it is also important to understand
the company’s current state regarding their deferred tax liabilities and deferred tax assets.
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a. Describe what is meant by the term book income? Which number in ZAGG’s
statement of operation captures this notion for fiscal 2012? Describe how a
company’s book income differs from its taxable income.
Ø The term book income refers to the pre-tax financial income that is
reported on a company’s income statement. Book income is calculated in
accordance with GAAP, while taxable income is calculated in accordance
with the IRS rules (tax code). For 2012, ZAGG reported book income of
$23,898,000 on its income statement. Differences between book income
and taxable income can either be temporary or permanent differences, or
the result of any carryforward or carryback losses.
b. In your own words, define the following terms.
i. Permanent tax differences (also provide an example)
Ø A permanent tax difference is the result of a transaction that is reported
differently for financial and tax reporting purposes. This difference is the
result of items that are either included in financial income but never
taxable income, or included in taxable income but never financial income.
Some examples of permanent tax differences are meals and entertainment
expenses, municipal bond interest, and penalties and fines.
ii. Temporary tax difference (also provide an example)
Ø A temporary tax difference is the difference between the tax basis of an
asset or liability and the asset or liabilities’ current book value on the
company’s financial statements. These differences result in taxable
amounts or deductible amounts in future years. Taxable amounts increase
taxable income in future years, while deductible amounts decrease future
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taxable income. Depreciation expense is a common example of a
temporary tax difference.
iii. Statutory tax rate
Ø The statutory tax rate is the tax rate mandated by the law. This rate may
differ based on a company or individual’s taxable income.
iv. Effective tax rate
Ø The effective tax rate is the average rate at which an individual or
corporation is taxed.
c. Explain in general terms why a company reports deferred income taxes as
part of their total income tax expense. Why don’t companies simply report
their current tax bill as their income tax expense?
Ø A company is required to report its deferred income taxes as part of their
total income tax expense due to the fact ignoring these items would be in
violation with the full disclosure principle of accounting. By definition,
deferred income taxes are the result of transactions that are deductible in
the current tax year, but will be taxed in a future year. Deferred taxes are
the result of future taxable amounts. Deferred taxes represent an amount
payable in the future, therefore meeting the requirements of a liability. For
a company to ignore the inclusion of this deferred tax liability in the
current year would be in violation of the full disclosure principle and
possibly lead to internal control deficiencies and financial statement
restatements.
Ø Guidance for the accounting treatment for income tax expense and
income tax payable is provided by the ASC 740. The ASC 740 is a set of
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financial accounting and reporting standards for the treatment of income
tax effects for current and future years. ASC 740’s principles and
requirements apply to both domestic and foreign entities. These entities
include not-for-profit entities and apply to federal, state, local, and some
foreign taxes based on income. Essentially, the ASC 740 applies to all
entities that remain a part of a reporting entity. Taxes not covered by the
ASC 740 include sales and use taxes, property taxes, payroll taxes, excise
taxes, VAT taxes, and capital (equity) based franchise taxes. The ASC
740’s primary objective is to recognize taxes payable during the current
year as well as taxes either payable or refundable in future years. The ASC
740 also provides rules and regulations regarding the reporting of deferred
tax assets and deferred tax liabilities relating to future tax consequences.
Ø The accounting for these deferred tax assets and liabilities is crucial to
guarantee full disclosure of a company’s current financial position.
Companies should be concerned with ASC 740 because it has the effect of
requiring organizations to track tax positions for both tax reporting and
financial reporting purposes. For many companies, the tracking of these
uncertain tax positions and the successful evaluation of the processes and
procedures can be overwhelming and complex. This tracking becomes
even more challenging when a company becomes exposed to multiple tax
jurisdictions. The consequences for incorrect reporting of tax positions can
result in major issues for the company. Companies that take aggressive
taxable income positions must disclose the information regarding their
uncertain tax position in the footnotes of their financial statements.
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Footnotes containing a high level of uncertain positions may spark the
interest of the IRS, state, or foreign tax authority and consequently result
in the challenging of the company’s tax reporting and previously filed
income tax returns. If these challenges result in a loss for the company, the
company may be forced to eliminate deductions or include additional
income items in the calculation of taxable income. This results in a larger
tax liability for the company, as well as a potentially negative effect on the
company’s net income. It is crucial for companies to abide by the ASC
740 rules for tax reporting regarding the inclusion of their income tax
payables into total income tax expense. According to GAAP, companies
are required to abide by the full disclosure principle, therefore required to
include all future liabilities on their financial statement. While it may seem
more intuitive to report only the current year’s tax expense on the financial
statements for that year, it excludes crucial liabilities of the company and
results in a violation of the full disclosure principle.
d. Explain what deferred income tax assets and deferred income tax liabilities
represent. Give an example of a situation that would give rise to each of these
items on the balance sheet.
Ø A deferred tax asset is the deferred tax resulting from deductible
temporary differences. The tax liability related to these future deductible
temporary differences is settled in the current period, therefore resulting in
an increase in taxes refundable in future years. For example, a deferred tax
asset would result from the deduction of a litigation loss for financial
reporting purposes but not for tax purposes in the current year. This loss
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will be deductible in a future year for tax purposes (when the liability is
paid), therefore creating a future tax savings amount (deferred tax asset).
While deferred tax assets may sound appealing, tax payers always prefer
to push back tax payments as long as possible; therefore, deferred tax
assets are unfavorable. A deferred tax liability represents the increase in
taxes paid in future years. Taxes resulting from taxable temporary
differences are payable in future years, therefore resulting in a future tax
liability increase. For example, a deferred tax liability would result from
the inclusion of accounts receivable in book income but not taxable
income. The individual or corporation would not be taxed in the current
year for the accounts receivable balance, however they have a liability to
pay the tax on this asset in a future year, therefore creating a deferred tax
liability. Deferred tax liabilities are favorable for the individual or
corporation being taxed.
e. Explain what a deferred income tax valuation allowance is and when it
should be recorded.
Ø A deferred income tax valuation allowance is used when a company
decides, based on available evidence, that it is more likely than not that it
will not realize some portion or all of the deferred tax asset. To justify the
use of a deferred tax valuation allowance, a company generally should
have a likelihood of not realizing the deferred tax asset of slightly more
than fifty percent. The amount entered into the valuation allowance
account should be determined at the end of the year. Increases in the
deferred income tax valuation allowance account serves as a contra
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deferred tax asset account, therefore decreasing the value of the deferred
tax asset.
f. Consider the information disclosed in Note 8—Income Taxes to answer the
following questions:
i. Using information in the first table in Note 8, show the journal entry
that ZAGG recorded for the income tax provision in fiscal 2012.
Income Tax Expense 9,393 Deferred Tax Asset 8,293 Income Tax Payable 17,686
** In thousands
ii. Using the information in the third table in Note 8, decompose the
amount of “net deferred income taxes” recorded in income tax
journal entry in part f. i. into its deferred income tax asset and
deferred income tax liability components.
Income Tax Expense 9,393 Deferred Tax Asset 8,002 Deferred Tax Liability 291 Income Tax Payable 17,686
** In thousands
iii. The second table in Note 8 provides a reconciliation of income taxes
computed using the federal statutory rate (35%) to income taxes
computed using ZAGG’s effective tax rate. Calculate ZAGG’s 2012
effective tax rate using the information provided in their income
statement. What accounts for the difference between the statutory
rate and ZAGG’s effective tax rate?
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Ø ZAGG’s 2012 effective tax rate for 2012 is 39.3 percent. The effective tax
rate is calculated by divided ZAGG’s income tax expense of $9,393 by
income before provisions of $23,898. The difference in the statutory rate
of 35 percent and effective tax rate of 39.3 percent is due to permanent
differences between income tax expense and income tax payable.
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Apple Inc.–Revenue Recognition
Case Study #11
103
Executive Summary
Introduction:
Apple Inc. designs, manufactures, and markets personal computers, mobile
communication devices, and portable digital music and video players. They also
sell a variety of software, services, and networking solutions. Apple sells its
products in several global markets through online retailing, retail stores, and third-
party wholesalers, resellers, and value-added resellers. This case addresses
Apple’s process of revenue recognition, as well as the current requirements
mandated by the FASB and IASB for the recognition of revenue. Recently, the
FASB and IASB issued a converged standard on revenue recognition titled,
Revenue from Contracts with Customers. This new standard is referenced
throughout the case.
Analysis:
Part A of this case explains the difference between revenues and gains. Revenue
can be defined as income from a company’s primary business operations, while
gains represent income resulting from a company’s peripheral activities. Gains are
usually the result of the sale of assets at a price greater than the assets current
book value. Part B deals with the recognition of revenue. According to the new
standard, Revenue from Contracts with Customers, revenue is to be recognized in
the period in which the performance obligation is satisfied. Just because a
company may receive proceeds from a customer does not justify the recognition
of revenue. The new standard outlines a five-step process for the recognition of
revenue. This process consists of identification of the contract with the customer,
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identification of the separate performance obligations outlined in the contract,
determination of transaction price, allocation of the transaction price to the
different performance obligations, and finally the recognition of revenue when
each performance obligation is satisfied. Part C addresses Apple’s specific
revenue recognition criteria. Apple states that for the recognition of revenue to be
justified, persuasive evidence of a contract exists, delivery has occurred, a fixed
sales price exists or is determinable, and the sale is probable. These four
requirements align with the requirements outlined by the revenue recognition
standard. Part D explains multi-element contracts and the obstacles they impose
on revenue recognition. Apple handles multi-element contracts by allocating the
different performance obligations based on their relative selling price. Part E
references the many incentives that management may be exposed to regarding
revenue. These incentives make the manipulation of revenue recognition quite
tempting for managers in some cases, therefore making the revenue recognition
guidelines very important. Finally, Part F discusses the different ways in which
Apple recognizes revenue for the sale of various products.
Conclusion:
This case shows the importance of revenue recognition and the many technical
difficulties management may face in recognizing revenue in accordance with the
FASB’s guidelines.
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a. In your own words, define “revenues.” Explain how revenues are different
from “gains.”
Ø Revenue is income recognized by a company originating from the
company’s primary business operations. Revenue is generally presented at
the top of the income statement, with all expenses subtracted below to
arrive at a net income number. The difference between revenues and gains
is that gains arise from a company’s peripheral activities, not the
company’s main operations. Gains usually result from the sale of an asset
at an amount greater than its book value.
b. Describe what it means for a business to “recognize” revenues. What specific
accounts and financial statements are affected by the process of revenue
recognition? Describe the revenue recognition criteria outline in the FASB’s
Statement of Concepts No. 5.
Ø According to the ASC 606 new revenue recognition standard, Revenue
from Contracts with Customers, revenue is classified as being recognized
in the period in which the performance obligation is satisfied. The key
objective of this new standard is to recognize revenue to depict the transfer
of goods or services to customers in an amount that reflects the
consideration that the company receives, or expects to receive, in
exchange for these goods or services. This standard adopts an asset-
liability approach, meaning that revenue is recognized based on related
changes in assets and liabilities. Accounts such as revenue, cash, accounts
receivable, sales, and unearned revenue are affected by the process of
revenue recognition. The revenue account is presented on the income
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statement; however, it also has significant effects on the balance sheet and
statement of cash flows. The new revenue recognition standard constitutes
a five-step process for the recognition of revenue. These five steps include
the identification of the contract created with the customer, identification
of the separate performance obligations defined in the contract,
determination of the transaction price, allocation of the transaction price to
the performance obligations, and finally, the recognition of revenue with
the satisfaction of each performance obligation.
c. Refer to the Revenue Recognition discussion in Note 1. In general, when does
Apple recognize revenue? Explain Apple’s four revenue recognition criteria.
Do they appear to be aligned with the revenue recognition criteria you
described in part b, above?
Ø According to Apple’s most recent 10-K, the company generally recognizes
revenue when “persuasive evidence of an arrangement exists, delivery has
occurred, the sales price is fixed or determinable, and collection is
probable.” These four revenue recognition criteria align with the revenue
recognition principles outlined in the new standard. Apple recognizes the
sale of a product when it is shipped, and title, risk of loss, and ownership
have all transferred to the customer. Apple states that all of these criteria
are usually met at the time the product is shipped. For online sales, the
company defers recognition until the customer physically receives the
product, due to the fact that they still retain certain risks of loss during
transit of the product. Apple recognizes revenue from standalone sales of
software products, sales of software upgrades, and sales of software
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bundled with hardware not essential to the functionality of the hardware in
accordance with industry-specific software accounting guidance.
d. What are multiple-element contracts and why do they pose revenue
recognition problems for companies?
Ø Multiple-element contracts are contracts that consist of multiple
performance obligations. These pose problems for companies in the way
in which they account for the revenue recognized for each of these
separate performance obligations. Being that the performance obligations
for these different elements of the contract are not satisfied at the same
time, the total contract price must be allocation to each separate
performance obligation, and recognized when satisfied. For Apple,
revenue relating to multiple-element arrangements that include hardware
products containing software essential to the functionality of the hardware,
undelivered software elements relating to the hardware’s functionality,
and undelivered not-software services, is allocated to all service
obligations based on their relative selling price.
e. In general, what incentives do managers have to make self-serving revenue
recognition choices?
Ø Management may be presented with certain incentives when the company
reaches a certain sales number or certain revenue goal within a specified
time span. These incentives may be prizes, cash prizes, trips, or bonuses.
These incentives tempt management to manipulate revenue recognition in
a way that makes the company look more profitable. For this reason,
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FASB takes a very strong approach to mandating revenue recognition
principles.
f. Refer to Apple’s revenue recognition footnote. In particular, when does the
company recognize revenue for the following types of sales?
i. iTunes songs sold online.
Ø Apple recognizes iTunes songs sold online when the item is transferred to
the recipient; therefore, the performance obligation is satisfied. Being that
there is no major time difference between the purchase and possession of
the song by the customer, revenue is generally recognized at the time of
purchase.
ii. Mac-branded accessories such as headphones, power adapters, and
backpacks sold in the Apple stores. What if the accessories are sold
online?
Ø Apple uses its four requirements of revenue recognition to determine when
to recognize revenue for accessories such as headphones, power adapters,
and backpacks. If these items are sold in store, the four requirements are
generally met at the time of purchase, therefore validating the recognition
of revenue at the point of sale. However, if these items were to be sold
online, Apple would delay revenue recognition until the customer
physically receives the item due to the fact that they still bear some
elements of risk during transit.
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iii. iPods sold to a third-party reseller in India.
Ø Apple generally accounts for revenue sold to third-party resellers at the
gross amount billed. Apple generally establishes its own pricing and
related risk when dealing with third-party sales.
iv. Revenue from gift cards.
Ø Revenue from the sale of gift cards would be deferred until the customer
actually makes a purchase using the gift card. The proceeds from the
initial sale of the gift card would represent unearned revenue for the
company until they satisfy the obligation to provide the products or
services that the gift card covers.